Prosperity and Depression

CHAPTER 3 THE OVER-INVESTMENT THEORIES

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§ 1.    GENERAL CHARACTERISTICS

Maladjustments, vertical and horizontal.

In this section, it is proposed to analyse some closely related theories of a great number of writers, which may be labelled generically “over-investment theories”.

The central theme of all these theories is the over-development of industries which produce producers’ goods or capital goods in relation to industries producing consumers’ goods. They all start from the universally admitted fact that the capital-goods industries are much more severely affected by the business cycle than industries which produce for current consumption. During the upward phase of the cycle the output of producers’ goods rises much more, and during the downward phase is much more curtailed, than the output of perishable consumers’ goods. Durable consumers’ goods, such as houses and automobiles, are in a special position approximating to that of capital goods.

According to the over-investment theorists, this phenomenon is the symptom of a serious maladjustment which develops during the upswing. The capital-goods industries, it is argued, are relatively over-developed: the production of capital goods as compared with the production of consumer’s goods is pushed farther than the underlying situation can permanently tolerate. Thus it is a real maladjustment in the structure of production that causes the breakdown of the boom, and not a mere shortage of money due to an insufficiency of bank reserves. It follows that, after the boom has once been allowed to develop, the setback cannot be staved off indefinitely by monetary measures.

The situation as it develops during the boom, according to the over-investment school, may be described as a “vertical disequilibrium or maladjustment” in contradistinction to a “horizontal disequilibrium or maladjustment” in the structure of production. The distinction between vertical and horizontal maladjustments can be formulated as follows. Supposing that by some means the aggregate money flow is kept constant, equilibrium in the structure of production will be preserved, if the allocation of the factors of production to various employments corresponds to the distribution of the money flow—i.e., the monetary demand for the products of the different branches of industry. This distribution is, broadly speaking, determined by (1) the decisions of the population as to spending and saving, (2) the decisions of consumers as to the distribution of expenditure between various lines of consumption goods, and (3) the decisions of producers at every stage as to the distribution of their cost expenditure between different forms of input. If the structure of production does not correspond to the first set of decisions, we have a vertical maladjustment—vertical because the industries which are not harmoniously developed are related to each other in a “vertical” order, as cost and product. One may also speak of “higher” and “lower”, or “earlier” and “later” stages of production—in which case “lower” and “later” mean “nearer to consumption”. If the structure of production does not correspond to the second or third set of decisions, we have a horizontal disproportion—a disproportion between industries of the same “rank” as measured by distance from consumption.

Money and the structure of production.

We have seen that Mr. HAWTREY also recognises the fact that the cyclical movement is much more violent in the capital-goods industries. But in his view, this is merely the consequence of fluctuations in the flow of money (consumers’ income and outlay). It is not an evil in itself. According to the over-investment theories, fluctuation in investment is the cause of the business cycle, and the forces which bring about expansion (being to a large extent of a monetary nature) have a direct effect on investment—viz. (mainly) on investment in fixed capital. Fluctuations in investment generate fluctuations in consumers’ income rather than the other way round.

Thus, according to these theories, the business cycle is not a purely monetary phenomenon. But that does not preclude the possibility of money’s playing a decisive rôle in bringing about the cycle and causing periodically a real maladjustment. Some members of the over-investment school consider monetary forces to be the impelling factor disturbing the equilibrium. Others believe that certain monetary arrangements are conditioning factors, which do not actively disturb the equilibrium but are the instruments through which the active forces of a non-monetary nature operate.

The schools of over-investment theorists.

We can distinguish three sub-groups with a still greater variety in detail.1

(A) Writers who believe that monetary forces operating under a particular form of credit organisation (banking system) produce the disequilibrium between the lower and higher stages of production.

This type of theory, which is frequently called the “Neo-Wicksellian” school, may perhaps be included amongst the monetary explanations of the business cycle, inasmuch as the active cause which disturbs the equilibrium is a monetary one. But the business cycle is for these writers more than a purely monetary phenomenon. Monetary forces produce a real maladjustment, the consequence of which is the breakdown of the boom. Crisis and depression cannot be explained purely by contraction of the circulating medium, although deflation may come in as a secondary and intensifying element. Among the writers whose theories fall within this group are HAYEK, MACHLUP, MISES, ROBBINS, RÖPKE and STRIGL. WICKSELL has provided the theoretical basis for this theory, but belongs himself rather to the following group (group (B)), while ROBERTSON holds an intermediate position between group (A) and group (B).

(B)   This group consists of writers whose theories do not run in terms of money. They stress factors in the sphere of production such as inventions, discoveries, the opening of new markets, etc.—that is, circumstances which provide new investment opportunities. Some of them refer to the money factor only incidentally or incline to minimise it. But it can be shown—and is indeed frequently recognised by the writers in question—that certain monetary forces are indispensable for the active factors on which they lay stress to produce the effect postulated. CASSEL, HANSEN, SPIETHOFF and WICKSELL are prominent in this group. ROBERTSON has been already mentioned. PIGOU’S and SCHUMPETER’S analyses go parallel for a long way with the theories of these writers.

(C) There is a third view which adds much to the force of the over-investment theory—namely, the theory that changes in the production of consumers’ goods give rise, for technological reasons, to much more violent fluctuations in the production of producers’ goods in general and fixed capital equipment in particular. This so-called principle of “the acceleration and magnification of derived demand” has been elaborated by AFTALION, BICKERDIKE, CARVER and PIGOU. In recent years, J. M. CLARK and R. G. HARROD have laid great stress upon it in their explanation of the business cycle. MITCHELL, ROBERTSON and SPIETHOFF mention it as a factor which intensifies the cyclical movement. The principle can also be used, as we shall see, in support of a special type of the under-consumption theory of the business cycle.

A. The Monetary Over-investment Theories

§ 2.    GENERAL CHARACTERISTICS AND THEORETICAL FOUNDATION

Banking system and money supply.

The theories of the following writers will now be examined: F. A. HAYEK,2 F. MACHLUP,3 L. MISES,4 L. ROBBINS,5 W. RÖPKE6 and R. STRIGL.7 The explanation given by these writers of the upswing and of the down-turn (crisis) is fundamentally the same. Such differences as exist are mainly in respect of amplifications in the later publications. Serious conflicts of opinion are to be found, on the other hand, in respect of the description and explanation of the downswing and the up-turn (revival). Professor RÖPKE, in particular, dissents strongly from the opinion of the other writers named in the interpretation of the later phases of such prolonged depressions as that of 1929-1936. The writers of this group have this in common with the purely monetary theory of Mr. HAWTREY, that they assume an elastic money supply. They argue that the circulating medium consists under modern conditions primarily of bank money (deposits), and that the banking system regulates the quantity of money by changing the discount rate and by conducting open-market operations. It has long been recognised that there is a complicated functional relationship between the interest rate, changes in the quantity of money and the price level. These relationships have been expounded systematically by KNUT WICKSELL; his theory, outlined below, is the basis of the explanation of the business cycle which follows.8 It should be added that, in what follows, we shall leave international complications for the moment out of account and disregard the fact that a change in the interest rate in one country will influence the flow of credit from and to other countries. These complications can easily be introduced into the picture later. For the present, we presuppose a closed economy.

Natural rate and money rate of interest.

WICKSELL distinguishes between the “money rate” or actual “market rate of interest” as influenced by the policy of the banks (and other monetary factors) on the one hand and the “natural rate of interest” on the other. The latter is defined by WICKSELL as “that rate at which the demand for loan capital just equals the supply of savings”.9 If the banks lower the market rate below this natural or, as it should perhaps more correctly be called, equilibrium rate, the demand for credit will rise and exceed the available amount of savings, and the supply of credit must be supplemented by bank credit created ad hoc— that is, by inflation. If, on the other hand, the rate is raised above the equilibrium level, the demand for credit will fall, some portion of the total saving will not be used, and credit will be liquidated or deflated.10 WICKSELL goes on to argue that, if the market rate is below the natural rate, prices will rise: if it is above, prices will tend to fall.

Two meanings of the concept “natural rate”.

There is, however, a fallacy in this last pro-position, as was pointed out for the first time by the Swedish economist DAVIDSON.11 In a progressive economy, where the volume of production and transactions rises, the flow of money must be increased in order to keep the price level stable. Therefore, the rate of interest must be kept at a level low enough to induce a net inflow of money into circulation. The rate which stabilises the price level is below the rate “at which the demand for loan capital just equals the supply of savings”.

Making allowance for this discrepancy, we may formulate the theorem as follows. If the banks lower the interest rate, ceteris paribus the flow of money incomes will expand or, if it was shrinking, the process of contraction will be stopped or slowed down: prices will rise or, if they were falling, the fall will be arrested or mitigated. If the banks raise the interest rate, ceteris paribus the flow of money incomes will contract or, if it was expanding, the expansion will be stopped or slowed down: prices will fall or, if they were rising, the rise will be arrested or mitigated. Under given conditions, there is one rate which keeps the price level constant and another which keeps the flow of money incomes constant. The two coincide only in a stationary economy. In a progressive economy, the rate which stabilises the price level is below the rate which keeps the flow of money incomes constant.

Which of these two rates is called the “natural” or “equilibrium rate” will depend on which is thought the likelier to maintain the equilibrium of the economic system. We shall see that those writers of the group under review, whose analysis takes account of the difference, reserve the adjective “natural” for the rate which keeps the flow of money incomes constant. But for the moment we shall ignore this distinction, which the writers in question themselves are by no means consistent in respecting.12

§ 3.    THE UPSWING

Interest rates and prices.

According to the theory with which we are dealing, the boom is brought about by a discrepancy between the natural and the money rate of interest. How this discrepancy is produced, and whether there is any reason why it should recur again and again in a more or less regular fashion, will be discussed later. If the money rate stands below the equilibrium rate, a credit expansion will ensue. As soon as prices begin to rise, the process tends to become cumulative for the reason that there is a twofold causal connection between interest rates and the price level. A low interest level tends to raise prices and a high level to depress them; but, on the other hand, rising prices tend to raise interest rates and falling prices to reduce them. If prices rise and people expect them to continue to rise, they become more eager to borrow and the demand for credit becomes stronger. Falling prices have the contrary effect. Rising prices are equivalent to a premium for borrowers, falling prices are a tax on borrowers. Professor IRVING FISHER distinguishes between the “nominal or money rate of interest” and the “real rate of interest”.13 The first is the rate as we find it in the market: the second is the money rate corrected for changes in the value of money in terms of goods and services. Thus, if prices rise by 3% during the year, a nominal rate of 5% is equivalent to a real rate of (approximately) 2%, because the purchasing power of the capital sum falls by 3%. If prices rise by (say) 10% a year, a nominal rate of less than 10% becomes equivalent to a negative real rate, because the creditor loses, in terms of real purchasing power, more on the capital than he receives as interest. If prices fall by (say) 10% annually, a money rate of 5% becomes equivalent to a real rate of about 15%.

Mr. HAWTREY proposes the term “profit rate” for true profits of business, which he describes as being the ratio of labour saved per annum by the capital actually in use to labour expended on first cost, corrected for price changes.14

Demand and supply of loanable funds.

The most convenient way of approach to the understanding of these rather complicated interrelationships is to conceive of the situation in terms of the supply of, and demand for, credit. The supply is furnished by the savings of individuals and corporations, supplemented by inflationary bank credits. The ability of the banks to create credit makes the total supply more elastic than it would otherwise be. A considerable increase in the demand will be met without much rise in the interest rate, though the supply of voluntary saving may have increased only a little or not at all. The demand for credit is a very complex and volatile phenomenon. We shall see later on, in connection with the analysis of other theories, that it is exposed to sudden influences from various sides and is subject to rapid changes. To elucidate the theories here under review it is sufficient to assume that, at any given moment of time, there is a negatively inclined demand schedule. The lower in such case the price of credit—i.e., the interest rate—the larger the amount of credit demanded.

We start from a situation where the banks maintain a level of interest rates at which the demand for, and supply of, credit exceeds the supply of savings. A credit expansion ensues, prices rise, and the rise in prices raises profits. The demand for credit rises: at each rate of interest, more is demanded than before. But the monetary expansion does not expand savings to the same extent, and the equilibrium rate of interest rises. Consequently,. if the banks persist in maintaining the same rate of interest, the gap between the equilibrium rate and the market rate will be even wider than before, and the amount of credit expansion required even greater. Prices rise higher still, profits are raised, and the vicious spiral of inflation continues. After the movement has gathered momentum, it can only be stopped by a considerable rise in the rate of interest being enforced by the banks.

The process need not be discussed in greater detail, because so far the monetary over-investment theory runs parallel with the purely monetary theory.15 The only difference is a difference of terminology—namely, the introduction of the terms “natural or equilibrium rate of interest” for a concept which is equally implicit in Mr. HAWTREY’S analysis.

The capitalistic structure of production.

So much for the monetary aspect of the upswing. But, according to the theory under review, it has its complement in a distortion in the structure of production, a maldistribution of economic resources. This “real” aspect it is now proposed to consider. The rate of interest has not only the function of regulating the quantity of money. Like every other price, it has, in an individualistic economy, the more fundamental function of serving as a guide to the allocation of the factors of production to the different branches in the production process. It is the vertical structure, more specifically, which is governed by the rate of interest. In order to explain this part of the price mechanism, it is necessary to go somewhat deeper into the theory of capitalistic production.

At any given moment, the available means of production are in some way apportioned between the various stages of production. Some of them are at work in the industries which produce consumers’ goods; others in the industries just before the last stage; others are applied to produce half-finished goods, raw materials, tools and machinery.

The apportionment of the factors of production devoted to the production of consumers’ goods and to the earlier stages of production respectively can, of course, be modified and is being modified continuously. Economic progress has to a large extent been conditioned by the fact that an ever-increasing proportion of the available productive resources has been devoted to earlier stages of production. New stages have been added or interpolated, with the result that the vertical structure of production has been elongated. In other words, the methods of production have become more indirect, more “roundabout” and more “capitalistic”, in the sense that a greater amount of capital, intermediate goods such as machinery and raw materials and half-finished products, is used per unit of output of consumable goods.16 The ultimate aim of the accumulation of capital is naturally an increase in the output of consumers’ goods. But the percentage increase in capital stock piled up behind the consumption industries is greater than the percentage increase in the rate of flow of consumers’ goods.

The force which determines the lengthening of the process of production is, broadly speaking, the rate of saving. The signals for the entrepreneurs to elongate the process are the availability of new capital and the lowness of the rate of interest.

Saving and interest.

If a part of current income is being saved—i.e., if not all income is devoted to buying consumers’ goods—the demand for consumers’ goods falls off and factors of production are made available.17 If the money saved is not withdrawn from circulation, but is offered in some way in the capital market, the rate of interest will fall and this will induce entrepreneurs to make new investments. There are always opportunities for investment which cannot be undertaken for want of capital. Labour-saving machinery can be installed (which involves the creation of a new stage in the process of production), railways can be electrified and in a hundred other ways the process of production can profitably be lengthened—if only the rate of interest is low enough and the necessary amount of capital available. It is the function of the rate of interest to select among the great number of existing opportunities for investment those extensions of the production process which can be undertaken with the existing supply of capital (savings). The rate of interest distinguishes those of the new roundabout methods of production which are permissible from those which are not.

If a certain plan of investment, which from the technological point of view seems to be productive and useful, cannot be realised for the sole reason that the expected yield would not justify the investment at the existing rate of interest—i.e., because the profit rate is lower than the prevailing rate of interest—that by no means proves the imperfection of our present pricing system, but simply shows that there exist other opportunities for improving the productive process which hold out a higher rate of return and should rationally, therefore, be undertaken first.

If 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.18

“Artificial” lowering of the interest rate.

From the point of view of the entrepreneur who wants to embark on new schemes of investment, the situation is not changed if the lowering of the rate of interest is due to capital’s having been made more plentiful, not by an increase in voluntary saving, but by an expansion of bank credit. Such an artificial cheapening of capital will also lead to a lengthening of the process of production. If we start from an equilibrium position of full employment with no excess capacity—we shall see later that the argument can also be adapted to apply to a situation with unemployment and unused plant—means of production will be drawn away from the consumption-goods industries. These industries will have to contract and the higher stages of production will expand.

This 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.19

Credit expansion and “forced saving”.

Obviously, the necessary condition is that the demand for consumers’ goods does not rise pari passu with the creation of credit and the rise in demand for capital goods. Either there will be a lag in the rise of aggregate incomes, or—what is probably the same thing from another angle—the increment of income will not at once be available (owing to discontinuities in the receipt of it) for expenditure purposes. Prices will thus rise quicker than disposable income, and consumption will be curtailed. In addition, the rigidity of certain contract incomes such as rents, pensions, salaries, etc., may have the effect of modifying the distribution of income in favour of classes who are more disposed to save and have greater incentives to do so, with the result that consumption will tend to be still further reduced. People are to some extent forced, and to some extent induced, to save more; and this “forced saving” has the same result as is usually brought abou tby voluntary saving—viz., a restriction of consumption and the release of productive resources for the production of additional capital goods. In other words, the real capital which is needed for the increased investment is extorted from the consuming public by means of rising prices.

Treatment 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 saving20 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.

Apart, 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”.21 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.”22

Neither Professor PIGOU nor Professor ROBERTSON seems to have in mind a reduction in total consumption, but only a re-distribution of consumption in favour of wage-earners, an augmentation of the real-wages bill, which, according to Professor PIGOU, brings with it an augmentation of capital. But this is the same type of mechanism envisaged by Professor HAYEK and Professor MISES as the instrument by which investment is financed in excess of voluntary saving in the case where an increase in capital involves a diminution of the flow of goods available for consumption. In the latter case, however, it is implied that the incomes created by the additional investment do not immediately become available to be spent or saved.

Professor 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.23

§ 4.    THE DOWN-TURN (CRISIS)

Why must this process of monetary expansion and heavy investment always end in a collapse? Why does it not go on indefinitely or tail off into a more stable situation?

Abandonment of over-capitalistic processes.

According to the over-investment theory, this is impossible, because, by the artificial lowering of the interest rate, the economy is lured into long roundabout methods of production which cannot be maintained permanently. The structure of production becomes, so to speak, top-heavy. Forces are set up which tend to restore the old arrangement. For some time, increasing advances by the banks enable entrepreneurs to carry on construction by the new roundabout methods. But sooner or later—and the later it happens the worse the result—it becomes clear that the newly initiated extensions of the structure of production cannot be completed, and the work on the new but incompleted roundabout processes must be discontinued. The investment boom collapses and a large part of the invested capital is lost.

Before discussing in detail how this comes about and what the external symptoms are, it will be useful to make the broad lines of the argument clearer by comparison with a centralised communistic economy.

The Russian Five-year Plan was a supreme effort to increase the “roundaboutness” of production and thereby the future production of consumers’ goods. Instead of producing consumers’ goods with the existing rather primitive methods, they curtailed production for immediate consumption to the indispensable minimum. Instead of food, shoes, clothes, houses, etc., they produced power-plants and steel works: they sought to improve the transportation system: in a word, they built up a productive apparatus which could turn out consumption goods only after a considerable period of time.

But 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.24

Exactly the same thing happens, according to the monetary over-investment theory, in our individualistic exchange economy at the turning-point from prosperity to depression during the ordinary business cycle. The only difference is this: what in a communistic society is done upon a decision of the supreme economic council is in our individualistic economy brought about as the net effect of the independent actions of individuals and carried out by the price and interest mechanism.

It is not so easy to trace this process in detail, step by step, as it is to convey the general meaning of the argument: and, at this crucial point, the reasoning of our authors is not always altogether clear and consistent. It should be kept in mind that we are still concerned with what happens at the end of the boom and with the nature of the maladjustment which necessarily emerges and leads to the collapse. What happens after the turn will be discussed later. We shall see that, once the depression has started, the whole economic scene is completely changed and quite different arguments apply.

Shortage of investible funds.

The proximate cause for the breakdown of the boom is almost invariably the inability or unwillingness of the banking system to continue the expansion.

Furthermore, 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.25 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.

As has already been said, the fact that banks are forced to stop expansion for monetary reasons is the proximate cause of the boom’s coming to an end. Shortage of capital causes the collapse; but the term “shortage of capital” is provisional and has to be used with great care. In the first instance, it may be interpreted in the monetary sense as equivalent to a shortage of investible funds.

The whole over-investment school, however, deny that the difficulty is a purely monetary one. They deny that monetary measures could avert the crisis, and contend that they could only postpone it. If all legal and customary limitations were removed and the necessary funds provided, the monetary expansion could go on, but prices would inevitably rise. There would be no end to this rise of prices, which would proceed with increasing rapidity like the German inflation in 1921-1923; and, if the credit expansion were not stopped, it would be brought to an end by a complete collapse of the monetary system—that is to say, the public would eventually abandon and repudiate the rapidly depreciating currency, as the German public started to do with the German Mark in 1923,

Hayek’s theory of capital shortage.

Great pains have been taken to explain this process in terms of relative prices and of supply and demand for particular types of goods. To Professor HAYEK we owe the most elaborate analysis. It runs as follows:

The 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 paribus26 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.

An 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.”27 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.

Faulty bookkeeping practices.

There 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,28 and the entrepreneur is tempted to increase his consumption. Capital in such case is treated as income.29 In other words, consumption exceeds current production.

The onset of the depression.

If the demand for consumers’ goods rises relatively to the demand for producers’ goods, consumers’ goods industries become relatively profitable, and factors of production are enticed away from the higher stages of production and employed in the lower stages. The price of labour (wages) and of other mobile means of production, which can be used in various stages and can be transferred from the higher to the lower stages, rises. This involves a rise in money cost, which affects both lower and higher stages of production. But, while in the lower stages demand has risen, this is not true of the higher stages. Hence losses and a curtailment of production in the higher stages. The collapse of the boom has begun.

It 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.30 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.31, 32 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.33 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.

This is the exact and full interpretation of what is loosely called a “shortage of capital”; and it is a shortage of capital in this well-defined sense that is supposed to be the real cause of the breakdown. “Shortage of capital” in this sense is equivalent to under-saving and over-consumption. If people could be induced to save more—that is, to spend a smaller part of their income on consumers’ goods and devote a larger part (through the intermediary of the capital market) to the purchase of capital goods—the flow of money and the structure of production would be brought into harmony and the breakdown avoided.

The fruits of the boom lost in. the crisis.

If 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.34

In the specific case of the American boom of 1925-1929, the authors are emphatic that the same thing applies to an expansion which does not lead to a rise in prices, but is just enough to prevent a fall in prices that would otherwise have taken place because of a continuous increase in the volume of production. For reasons which will be expounded in the subsequent pages, it seems, however, that the undertaking to prove this latter point rigorously has not been made good.

Neisser’s criticism.

In his Prices and Production,35 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”36 and “the money stream will be re-distributed between consumptive and productive uses”37 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.

But, as Professor NEISSER38 has shown, there is no reason to expect this return to the old arrangement, if the new roundabout methods of production have been brought to completion. When they are completed, the flow of consumers’ goods which was temporarily reduced will rise again, and will even reach a higher level than that from which the expansion started, so that consumers can safely expand their consumption. Forced saving will cease to be necessary when the new processes of production are completed. When they are completed, all that is required to maintain them is that the entrepreneurs—not the consumers—should refrain from “disinvestments”, that is, from consuming capital or from spending amortisation quotas on consumption. There is no reason why the old proportion between money spent for consumers’ and for producers’ goods should be restored. It is not true that the whole of newly injected money becomes income either at once or after a while. Part of it must be retained by the entrepreneurs in order to pay for intermediate goods (in contradistinction to payments for the original factors of production). In other words, only a part of the new money becomes income. Another part remains permanently in the business sphere. It is only if entrepreneurs “dissave”—i.e., if they eat up their capital and refrain from investing that part of their gross receipts which is not net income (working capital and amortisation quotas)—that the pre-inflation arrangement is restored.

We may conclude that the theory under review is bound either to assume that the former proportions between capital and income will be restored by actual capital consumption or that the expansion must be discontinued before the new processes have been completed—or rather before all the new processes have been completed. This latter qualification seems to be called for, and is important, because it sheds doubt on the contention that no permanent extension of the process of production can be effected by a credit expansion. It is a plausible assumption that, when the expansion comes to an end, there will always be some new processes in an incomplete state. But there is no reason why others should not have been completed. The latter can be retained when the former have to be scrapped. This cessation of work is the essence of the crisis.

But why must there be any incomplete processes at all when the expansion has to end? Professor HAYEK admits the possibility of the expansion’s tailing-off gradually, in such a way that the started processes are completed but no new ones are inaugurated (except where voluntary savings are available). But, evidently, he does not believe that this possibility has any practical importance. Much seems to depend on the intensity of the expansion and on certain “indivisibilities”, on which Professor ROBERTSON lays so much stress. But the writers of the. group under review have not discussed this point in detail. We shall have occasion to deal with it in another connection.

Why need the expansion end?

It is evident that no collapse would occur if the credit expansion could go on indefinitely. It follows—the point is made by Professor HAYEK himself—that a crisis is equally inevitable in the case of voluntary saving if the flow of saving is suddenly reduced. It is, however, asserted—although the reasons given are not always quite convincing—that sudden changes are not likely to occur in respect of voluntary saving, while forced saving must come to an end abruptly. It is therefore very important to ask why should the expansion of credit stop. The answer is that in a closed economy, leaving out of account purely monetary and institutional factors (inability of the banking system to continue expansion within the limits fixed by the gold standard or some other legal or customary rules), the continuance of the expansion will involve a progressive rise in prices. A progressive rise in prices and the danger of a complete collapse of the monetary system is the only insurmountable barrier which prevents an indefinite continuation of the expansion.39

It seems to follow that the present theory does not prove, as it claims to do, that a credit expansion which does not lead to a rise in prices but only prevents a fall in prices must have the same evil effect as the more violent type which brings about a rise in the absolute price level. In a progressive economy, where the output of goods in general grows continually and prices tend therefore to fall, there is scope for a continuous expansion of credit at a steady rate.

Necessity of quantitative assumptions.

Against this objection, the following argument has been advanced.40 It is true, in an economy where the output, owing to improvements in the methods of production, grows at a constant rate, that a steady expansion in terms of money may be made: that is to say, per unit of time a constant amount of new money may be put into circulation.41 But even if this is just enough to keep the price level of finished goods constant, prices of factors of production will rise continuously. Hence, successive additions to the money stock will only be able to buy successively diminishing amounts of the factors of production. But, to render the completion of the newly initiated processes of production possible, the entrepreneurs in the upper stages must be enabled to absorb factors of production àt a constant rate; and, as the prices of factors of production rise, a credit expansion at an increasing rate will be necessary to enable them to do so. The conclusion is that a relative inflation, such as can be made within the limits of a constant price level, is not sufficient to allow of the completion of the new roundabout methods of production which have been initiated under the stimulus of the expansion. Either the rate of expansion of credit will be sufficiently increased and prices will be driven up and the inevitable breakdown will be postponed, or the boom will collapse at once owing to an insufficiency in the capital supply.

Incomplete assumptions.

This reasoning is, however, not convincing. The result will depend on a complicated quantitative relationship between certain factors—namely: (a) the rate of progress of the economy: that is, the rate of increase in efficiency or output which determines the rate of credit expansion that can be made without raising the price level; (b) the supply of capital which is required in successive periods to make possible the completion of productive processes which have been started in the past. In respect to both factors, Professor HAYEK’S argument makes implicitly certain assumptions, the bearing of which is not quite clear. The problem has not been either clearly visualised or explicitly stated. The concrete circumstances by which the magnitude of the two factors is determined are left vague. It is open to grave doubt whether generalisations can be made on this point without extensive factual investigations.

In any case, the theory in its fully developed form seems to make the emergence of a serious disequilibrium dependent upon relatively small fluctuations in the rate of forced saving. This being so, the question arises whether fluctuations of this order of magnitude are not equally likely to occur in the flow of voluntary savings.42 If they do occur, evil consequences must be expected, even in the absence of credit inflation. (We shall see, in connection with the discussion of other theories, that there are numerous other disturbances possible which may interrupt the upswing and start a vicious spiral downward—disturbances which are probably of the same, or even of a higher, order of magnitude than the fluctuations in the rate of forced or voluntary saving discussed above.)

To sum up, we may say that the theory has not proved rigorously that a stabilisation of prices in a progressive economy must always lead to over-production, crisis and depression.43 The practical importance of this conclusion is considerable in view of the American prosperity in the twenties, a notable feature of which was the fact that wholesale prices did not rise.

§ 5.    THE DOWNSWING

The depression as a period of readjustment.

The theory of the depression is not nearly so fully elaborated by the authors of the monetary over-investment school as the theory of the boom. The depression was originally conceived of by them as a process of adjustment of the structure of production, and was explained in non-monetary terms. During the boom, they argued, the process of production is unduly elongated. This elongation has accordingly to be removed and the structure of production has to be shortened or, alternatively, expenditure on consumers’ goods must be reduced (by retrenchment of wages and other incomes which are likely to be spent wholly or mainly on consumers’ goods) sufficiently to make the new structure of production possible. This involves a lengthy and painful process of rearrangement. Workers are thrown out of work in the higher stages, and it takes time to absorb them in the lower stages of production. In modern times especially, with inflexible wage systems and the various other obstructions represented by all kinds of State intervention, this process of shifting labour and other means of production is drawn out much longer than is necessary for purely technological reasons.44

The secondary deflation.

This non-monetary explanation of the depression is, however, admittedly incomplete and unsatisfactory. The majority of the authors of the group under review were at first very reluctant to recognise that there is a cumulative process of contraction corresponding to the cumulative process of expansion. But eventually it was admitted that, in addition to the difficulties which must arise from the fact that the structure of production does not correspond to the flow of money (in other words, the disturbances which result from the deflection of the money stream from the higher to the lower stages of production), there must be a deflation—that is, a shrinkage in the aggregate flow of money. The difficulties which result from this general shrinkage in the flow of money are superimposed on the disturbances involved in the necessary readjustment in the structure of production. Without assuming a general deflation, it is impossible to explain why the depression spreads to all stages and branches of industry, why it is not confined only to those industries which are over-developed and must therefore eventually contract (the higher stages), but extends also to those which are under-developed and must therefore eventually expand (the lower stages). It has become customary to speak of “secondary deflation”, by which it is intended to convey that the deflation does not come about independently, but is induced by the maladjustment in the structure of production which has led to the breakdown. Without the latter, it is believed, the deflation would not start at all.

The mechanism of secondary deflation has not been analysed very closely by the members of the school under review. Broadly speaking, there are two views.

(a)   Professor RÖPKE has studied the question in various publications45 and has come to the conclusion that the process of deflation has a tendency to become cumulative and self-perpetuating. Genetically, it is true, it is connected with the extravagances of the preceding boom and the real maladjustment which the boom has produced. But the intensity of the deflation by no means necessarily corresponds to the extent of the over-investment. It is also untrue, he believes, that the deflation contributes (as is more or less vaguely suggested by the other authors of the monetary over-investment school) to bringing about the necessary adjustment (shortening) in the process of production. Once started, the deflation is propelled by its own momentum and by a number of institutional factors. What these factors are and how they work, we shall discuss at greater length in another connection. HAWTREY, KEYNES, PIGOU and ROBERTSON have contributed most towards the understanding of this phenomenon.46

Those who believe that the deflation has a life of its own, so to speak, which is largely independent of the disequilibrium bred out of the preceding boom, are naturally inclined to assume that it can be directly counteracted, even if the boom has been allowed to give rise to a maladjustment in the structure of production.

(b)   The other group, in which we may reckon HAYEK, MACHLUP, MISES, ROBBINS, STRIGL, is, or was, of the opinion that the deflation is the necessary consequence of the boom. If once the boom has been allowed to develop and to give rise to maladjustments, the price has to be paid in the shape of a process of deflation. It is admitted by some that, at a certain point in the contraction process, an injection of money may help to shorten the contraction. But they warn us at once that the medicine is very dangerous, that it has to be given in careful doses, and can be useful only at a certain stage of the process and must be administered in a certain way, and will do harm if any one of these conditions is not strictly complied with. As this is too much to expect from the monetary authorities, the only practical policy is to let the deflation run its course and avoid interventions which would only make things worse.

The struggle for liquidity.

The most coherent theory of the depression along these lines is that of Professor STRIGL.47 He admits that the breakdown of the boom induces a process of hoarding and deflation. After the breakdown of the boom, the banks will not merely stop expansion: they will contract credit in order to increase their liquidity. Under the influence of the general feeling of insecurity and pessimism, industrial firms will also seek to strengthen their cash reserves, and amortisation quotas will be kept in liquid form instead of being invested. This general struggle for liquidity involves hoarding. It means that money, whose function it is to be the vehicle of investment of real capital, fails to fulfil this function and is sterilised for the time being in swollen cash reserves or, in the case of bank money (deposits), annihilated altogether. The general price fall which ensues operates as a further deterrent to investment. The profit rate falls below the money rate. Perhaps the most important external symptom of this process is the intense liquidity and the extremely low rates on the money market which develop during the depression. The low money rates are caused by the fact that the overflow of funds from the money market to the capital market is impeded by an invisible barrier of distrust and pessimism.

It goes without saying that the writers of the group not only admit, but even stress, the fact that the pressure of deflation is intensified and prolonged by all kinds of ill-advised intervention by the State and other public bodies, such as the competitive raising of tariffs, the scramble for gold in order to liquidate existing gold-exchange standards, and all similar measures designed to keep up prices and incomes.48

§ 6.    THE UPTURN (REVIVAL)

The effective quantity of money.

If left to itself, the economic system would gradually return to equilibrium with reasonably full employment of all productive resources. The equilibrium could be maintained, if only the banks would refrain from a new credit expansion—in other words, if the money rate of interest were kept on the equilibrium level. The equilibrium rate is implicitly or explicitly defined as that which keeps the effective quantity of money (MV) constant.

The concept “effective quantity of money” is very complicated. It is not easily defined in theory and is hopelessly difficult to measure statistically. The difficulty comes in principally through the factor “V”. The velocity of circulation meant is not the transaction velocity, nor is it the income velocity. One might perhaps call it trade velocity, the term being understood to cover all transactions which involve an exchange of goods in all stages of production, but to exclude financial transactions (e.g., on the stock exchange). If the quantity and the transaction velocity of money remain constant, but at the same time the requirements of the financial circulation rise, the result will be a decrease in the effective quantity of money as defined above. But these qualifications are not yet sufficient. Allowance must also be made for integration and disintegration of the process of production. If two or more successive stages in a particular line of industry (such as spinning and weaving), which are carried out by independent firms, are integrated by the formation of a vertical trust, the transfer of the intermediate product from the higher to the lower stage, which formerly gave rise to monetary transactions, may in future be effected by mere entries in the books of the new firm. Thus the merger may set free a certain amount of money. The trade velocity of money need not be changed, but the supply of money ought to be restricted; otherwise inflationary consequences will ensue.49

From these considerations, it follows that the prescription to “keep the effective quantity of money constant” is by no means an easy one to follow.

Recovery in demand for credit.

The writers of the group under review are, however, well aware of the great danger that the discrepancy between the money rate and the equilibrium rate of interest, which prevailed during the depression, will at once be succeeded by a discrepancy in the opposite direction. In view of the falling prices and the state of pessimism and discouragement, the money rate during the downswing stands above the natural rate. When the fall of prices comes to an end and pessimism gives way to a more optimistic outlook, the current money rates, without being changed, will soon stand below the equilibrium rate. In other words, the equilibrium rate is likely to rise above the money rate.50 In terms of supply and demand, this can be expressed by saying that the credit demand curve will move to the right or, loosely speaking, that demand will rise. At the same time, the banks will be in a liquid position, and there is every reason to expect that they will liberally comply with the increased demand for credit. The barrier between the money market and the capital market is broken down, and the funds accumulated behind the barrier flow into the investment market.51

Thus a new upswing starts smoothly—at first, almost imperceptibly—out of the ashes of the last boom. No special stimulus from outside is required in the shape of inventions, crop changes, discoveries, etc. We shall see, however, that the writers of the next group believe that such an incentive from outside is necessary. In this respect the present theory is the more “endogenous” in the previously defined sense. But it would seem to be difficult and not very helpful to lay down hard-and-fast rules as to whether the upswing must be assumed to be brought about by forces “internal” or “external” to the economic system.

Expansion from a position of partial employment.

It is convenient at this point to introduce the question of the existence of unused productive resources of all kinds. The explanation given by the writers of the school under review for the upswing, or rather for the boom, almost invariably starts from an equilibrium position with full employment of the means of production.52 But the argument can easily be adapted to the other case. If there are unemployed resources, evidently the expansion of credit may go on much longer than when all resources are employed. There need, then, be no shift of factors from the lower to the higher stages, but only the absorption of unused resources predominantly in those stages of production which are especially stimulated by the expansion—namely, in the upper stages (capital goods industries). Arguing along the lines of the theory under review, one has to assume that the unemployed resources are mainly put to work in the higher stages (capital-goods industries). But, so long as there is a reserve of unemployed resources, the reaction from excess investment, which consists (as we have seen) of a comparative rise in the demand for consumers’ goods, will not produce a breakdown, since there is no necessity to detach factors of production from the higher stages. Prices need not rise much. The expansion of credit can go on.

This process has never been analysed so closely as the process of expansion starting from a position of full employment.53 But, applying the same type of reasoning, the conclusion seems to be as follows: A disequilibrium between the higher and the lower stages is produced by the fact that the unemployed resources are not distributed among the different stages of production in the way they ought to be if ultimate equilibrium is to emerge. A larger amount is absorbed into the higher stages than can in the long run be employed there with the given rate of voluntary saving. Thus the recovery from the depth of the depression has a wrong twist from the beginning.

§ 7.    RHYTHM AND PERIODICITY

The ideological basis of inflation.

Professor MISES gives the following answer to the question why the cycle of prosperity and depression recurs again and again.54 The behaviour of the banks is responsible for the occurrence of the business cycle. If the banks did not push the money rate below the natural rate by expanding credit, equilibrium would not be disturbed. But why do the banks make the same mistake again and again? “The answer must be: because the prevailing ideology among business-men and politicians looks on the reduction of the rate of interest as an important aim of economic policy, and because they consider an inflationary expansion of credit the best means to attain that objective” (page 58). “The root cause of the phenomenon that one business cycle follows the other is thus of an ideological nature” (page 60).

Professor MISES believes, furthermore, that the commercial banks alone without the support of the central bank can never produce a dangerous credit inflation, because they would immediately lose cash and become insolvent. It is only with the backing of the central bank that it is possible to expand credit sufficiently to produce a dangerous boom. The ability of the central banks to increase the circulation is due to the monopoly which they hold of the issue of bank-notes. If the issue of notes were not a monopoly, if competition were restored in this field of the central banks’ activities—that is to say, if every bank had the right to issue notes, convertible into legal tender money (gold)—a dangerous expansion of credit and reduction of the interest rate would be impossible. The unsound banks would quickly be eliminated, and the sound banks would learn by experience that expansion is punished by bankruptcy.55

What banking policy will eliminate the cycle?

All the other members of this group of writers believe that the solution of the problem of the rhythmic nature of the cycle is not so simple as the above.

They would all probably agree that there must exist some form of banking policy by following which the business cycle would be eliminated. But they have become more and more conscious of the difficulties of giving precise criteria for the ideal policy. It is not a sufficient explanation to say that from time to time banks lower the rate too much. As has been pointed out above, it is rather the rise in the equilibrium rate than the fall in the money rate which creates the discrepancy between the two.

It follows that it is impossible to define the policy which the banks should pursue in negative terms by saying that the banks should refrain from lowering the rate of interest. It must be stated in positive terms that they should vary the rate in such a way that no credit expansion or contraction ensues in the face of changing demand for credit. But this, again, seems simple and exact only on a superficial view. It has been pointed out above how difficult it is, even in theory, to define exactly what is meant by saying that the effective quantity of money should be kept constant. In addition to the theoretical difficulty of giving exact criteria, there is the extremely difficult task of applying these criteria in concrete cases.

Professor HAYEK has pointed out that, for the individual banker, it is impossible to distinguish between deposits which have been created by voluntary saving and deposits which have an inflationary origin. The velocity of circulation of money, especially of bank money (deposits), may change without affecting the reserves of the banks. Neither bank reserves nor reserve ratios nor the price level are an unfailing criterion of the correct credit policy from the standpoint of the theory under review. Expansion may take place without any action on the part of the banks.

Cyclical implications of seasonal variations in credit.

Professor MACHLUP56 has called attention to one factor which helps to explain the recurrence of the cycle and throws into relief the passive rôle of the banks, at any rate during the first phase of the upswing. It is this. A considerable portion of the payments which have to be made during a given period, say a year, are not evenly distributed, but are concentrated at certain dates, some of them at the end of each month and others at the end of each quarter. Therefore, even with the most elaborate clearing and compensation arrangements, no complete continuous offsetting of the debts and liabilities of each firm is possible. At the critical dates, at the end of the month and of the quarter, there is therefore always a strong demand for short-term credit and a resultant strain on the money market. If the banks were not able and willing to relieve this monthly and quarterly tightness of money by granting temporary credits, individual firms would be compelled to provide for their requirements at the critical dates by accumulating cash during the intervals between them. But, as the banks lend money to overcome these difficulties—credit expansion for such a temporary stringency being generally regarded as perfectly legitimate and safe—it is not necessary to accumulate cash, and the sums involved can be invested instead.

It is clear that we have here a source of inflation; and the inflation, according to Professor MACHLUP, will not be confined to the single occasion of the first introduction of these “ultimo loans”, but will tend to recur cyclically. “While the utilisation of temporary surplus cash together with (inflationary) bank credit created the possibility of initiating illicitly long processes of production, the depression, after the elimination of the untenable enterprises, will release these sums again” (pages 175 and 176). During the depression, the investment of these sums is impossible, and they accumulate on the money market; but, as soon as the spirit of enterprise revives, they can be utilised for financing the boom for a long time without any, or with very little, additional bank credit.57

Summary.

We may conclude that the question why one cycle follows another without interruption cannot be answered, on the basis of the theory under review, by a simple formula. The inevitability of the sequence “forced saving—breakdown—depression” has been somewhat whittled down. The severity of the decline is no longer believed to vary rigidly with the degree of the structural maladjustments which gave rise to it. There is no longer the same confidence in the inevitability or the curative function of the depression. Above all, it has been realised to be impossible to fix the sole responsibility for the boom on the expansionary propensities of the banking system. Even in a purely cash economy, movements of hoarding and dishoarding might be induced, with the result that waves of expansion and contraction of economic activity would take place. It thus seems impossible to reduce to a few simple rules the problem of what ought to be done to eliminate the cycle. The high expectations which were originally entertained in this respect have given way to a much more cautious and much more sceptical attitude.

§ 8.    INTERNATIONAL COMPLICATIONS

Guiding principles.

A systematic account of the international aspect of the business cycle on the basis of the theory hitherto under consideration has never been attempted. With the help of the theory of the international money mechanism, it is, however, possible to trace out the way in which (if one accepts the monetary over-investment theory) the course of the cycle in a particular country must be influenced by its position in the international economy, and the manner in which the cyclical movement in such country is likely to react on the country’s international trade and on the internal situation of other countries.

As in the case of the purely monetary explanation of the business cycle, the first questions to be asked are: How does a given change in the international situation of a country influence the expansion or contraction of credit? Is it likely to facilitate and prolong, or retard, an expansion already under way? How is a contraction in process influenced by a given change in other countries? It is impossible to enumerate and systematise at this point all the conceivable contingencies. But a few principles may be laid down and some illustrations be given.

Influences through the balance of payments.

Any improvement in the balance of payments—that is to say, any increase in the demand for the means of payment of a given country in terms of the money of other countries—will have an expansionist influence. This improvement may be due to a great variety of circumstances—changes in the demand for particular commodities, crop changes, capital movements, etc. The erection of new tariff walls by an individual country, if not followed by compensatory action on the part of other countries, will have a favourable influence on the international monetary situation of the country which has raised its tariffs. In other words, it will enable the latter to expand its circulation without a deterioration of its exchange rate. Thus, the immediate influence of protectionist measures may be a stimulation of prosperity or an alleviation of depression. But the conditions in which this is true must be borne in mind. If many countries pursue this policy at the same time, the stimulating influence is lost. In the long run, the raising of tariff walls impairs the national dividends of all the countries involved.58 Indirect effects (e.g., on capital movements) may prevent even the immediate stimulation afforded by protectionist measures. Finally, an improvement in the balance of payments can always be utilised as a means of increasing the gold and foreign-exchange reserve in lieu of expanding the circulation.

While international influences are capable of stimulating of retarding a process of expansion or contraction, they may also arrest and reverse it—that is to say, international forces may start a revival or precipitate a crisis and depression in a country.

The gold standard.

Under the gold standard, the monetary authorities are obliged, if the country is losing gold, to put the brake on expansion. Gold may flow out either because the country has expanded more rapidly than other countries and prices are getting out of line with those in the rest of the world, or because other countries have started to contract or because there is a movement of capital (which may have been brought about by a great variety of causes), or because of a crop failure which necessitates increased imports or reduces exports, etc. Instead of contracting, a country may choose to leave the gold standard. If this is not thought safe, as being likely to lead to a flight of capital, resort may be had to exchange control. Thus, innumerable possibilities may arise, which cannot all be worked out at this point: but they can easily be analysed in the way indicated, although it may be extremely difficult to foresee in any given case the outcome of the many forces and reactions involved.

The fact that a crisis and depression or a revival is brought about in one way or another by “international forces” in no way, therefore, invalidates the theory of the business cycle, even though the theory has been elaborated without taking into account these international complications.

International capital movements.

In arguing on the basis of the over-investment theory, special attention must be paid to international capital movements.59 They not only affect the purely monetary situation by stimulating or retarding the expansion or contraction of credit: they have also a bearing on the structure of production. An individual country may finance a boom, wholly or partly, by capital imports from other countries instead of by an internal expansion of credit and forced saving. So long as this is possible, the reaction which the theory under review holds responsible for the breakdown—namely, a corresponding rise in the demand for consumers’ goods—may be staved off. Thus, in so far as a particular country is concerned, the boom may be prolonged. On the other hand, international capital movements are subject to risks and disturbances which are absent in the case of an internal expansion.

The composition of exports and imports.

An interesting question is how the composition of exports and imports of a country changes during the different phases of the cycle. It might be supposed that capital imports during the upswing are bound to be effected through the import of capital goods. As a general statement, this would, however, be wrong. In any given situation in respect of tariffs or otherwise, what a country imports will depend on the comparative cost situation or, in other words, on the comparative facilities of the various countries for the production of different types of goods. It is conceivable that capital for investment purposes may be imported, not in the shape of capital goods (raw materials, machinery, electrical equipment, etc.), but in the shape of consumers’ goods. This will be the case in a country where capital-goods industries and the production of raw materials are well developed, while consumers’ goods industries are less so.60

It is difficult to find concrete examples which illustrate this proposition, since in actual fact the situation is usually very complex. Countries do not usually specialise solely in the production of consumers’ goods, capital equipment, or raw materials, etc. Still, the economic equipment is usually deficient in various directions, though protectionist policy has done much to diversify national production and lessen international specialisation. On the whole, industrial countries are at the same time exporters of capital. Therefore, it is natural that capital movement should take place chiefly through the shipment of machinery, railroad and electrical equipment, etc. The outstanding example of capital movements taking place through the import of foodstuffs, other articles of consumption and raw materials is Germany in the post-war and post-inflation period—that is, from 1924 to 1928.

It is hoped that these remarks give an idea of the almost endless multiformity of the international complications, and at the same time of the possibility of analysing each of these innumerable cases with the help of a few principles, and of understanding them as special cases which can be brought under the general doctrine.

§ 9.    CONCLUDING REMARKS

The most valuable and original contributions of the monetary over-investment theory are (1) the analysis of the maladjustment in the structure of production brought about by the credit expansion during the prosperity phase of the cycle and (2) the explanation of the breakdown as consequent on that maladjustment. But our analysis has also shown that the theory is not in all respects complete. The claim to exclusive validity is open to doubt. It is a little difficult, for example, to understand why the transition to a more roundabout process of production should be associated with prosperity and the return to a less roundabout process a synonym for depression. Why should not the original inflationary expansion of investment cause as much dislocation in the production of consumers’ goods as the subsequent rise in consumers’ demand is said to cause in the production of investment goods?61

As to the explanation of the depression, especially the later phases of the depression, there is not a high measure of agreement between the various members of the school. So far as the existence of a vicious spiral of deflation is admitted, the analysis of the deflation is, on broad lines, not dissimilar from the analysis given by writers of other schools.

B.    The Non-monetary Over-investment Theories

§ 10.    GENERAL CHARACTERISTICS

Principal authors.

The most prominent writers in this group are Professors A. SPIETHOFF62 and G. CASSEL.63 In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI.64 Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany,65 but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.

With regard to Professor CASSEL, it must be remarked that we are here dealing primarily with the theory as expounded in the earlier editions of his Theory of Social Economy. In his later books and especially in his popular writings, he has more or less accepted a purely monetary explanation, at least so far as the 1929-1936 depression is concerned.66

It is significant that Professor SPIETHOFF, with his quite different theoretical background, has reached, so far as concerns the interpretation of the later phases of the upswing and of the situation which leads to the collapse, substantially the same result as the writers of the monetary over-investment school and Professor CASSEL.

Stress on production of capital goods.

The difference between the monetary and non-monetary over-investment theories concerns, as the names suggest, the rôle of money and monetary factors and institutions in bringing about the boom and the over-investment which leads to the collapse and depression. The theory of the writers of this group does not run in monetary terms; they mention monetary forces, but relegate them to a relatively subordinate rôle. It can, however, be shown that they are compelled to assume an elastic currency or credit supply in order to prove what they wish to demonstrate. But monetary factors are for them passive conditions which can be taken for granted rather than impelling forces.

Both Professors SPIETHOFF and CASSEL emphatically assert that the business cycle is characterised by changes in the production of capital goods, especially of fixed capital equipment. The production of consumers’ goods does not exhibit the same regularity of change during the business cycle. Professor SPIETHOFF makes the point that upswings have occurred during which consumption has actually fallen. This was the case, according to him, in Germany in the years 1845-1847/48, when the economic situation of the working classes positively deteriorated because of rising food prices due to a series of crop failures.67 But, even if no account is taken of changes in agricultural production, which are only remotely connected with the ups and downs of industrial production, “the production of consumption goods shows no marked dependence on trade cycles. This means that the alternation between periods of boom and slump is fundamentally a variation in the production of fixed capital, but has no direct connection with the rest of production.”68

§ 11.    THE UPSWING

Cumulative expansion process.

Professor SPIETHOFF describes the mechanism of the cumulative and self-sustaining process of expansion, which begins to work after the dead point of the depression has been overcome, in approximately the same way as the monetary over-investment school. (In respect to this particular problem, indeed, there is now much agreement even outside the schools which we have analysed so far.) The revival of investment activity generates income and purchasing power. Demand rises, first for capital goods and investment materials (iron, steel, cement, lumber, bricks) and later also for consumption goods. Prices rise, mainly prices of capital goods and investment materials. This stimulates further investment. Profits are made which swell the funds available for investment and provide an important psychological stimulus for further expansion. Thus, like a snowball, prosperity increases rapidly as it proceeds.

The monetary side of this process is not closely analysed. But Professor SPIETHOFF admits that “credit is an indispensable means to the upswing”.69 Professor CASSEL is less explicit in this respect. But it can be inferred from various remarks which he lets fall that he realises the necessity for an elastic currency supply. Both writers seem to believe that monetary funds are accumulated during the depression, on which the producers can draw during the upswing to finance the expansion. It follows that no positive steps need be taken by the banking system, at any rate during the first phases of the upswing. It is, however, not denied that, after a certain point, support by the banks is required to carry on. These monetary conditions and the monetary mechanism of credit expansion have been more thoroughly explored by the monetary school. In the writings of Professor ROBERTSON, Mr. KEYNES and Professor PIGOU (all of whom have much in common with SPIETHOFF and CASSEL) will be found the best synthesis of the monetary and non-monetary aspects of the process.

§ 12.    THE DOWN-TURN (CRISIS)

Shortage of capital.

The non-monetary over-investment school offers its most valuable contribution to the theory of the business cycle in connection with the explanation of the breakdown of the boom. The upswing cannot go on indefinitely; but how, precisely, is it brought to an end?

Professor SPIETHOFF rejects all under-consumption theories which assume that the collapse is due to a shrinkage of the demand for consumers’ goods, or to its failure to rise (owing to the lag in the rise of wages behind the rise of prices and profits), or to the fact that too much is being saved by individuals and corporations. He believes, on the contrary, that it is an actual shortage of capital that brings about the crisis; and he is at great pains to point out that capital shortage does not mean simply a deficiency of monetary funds, but is the symptom of a serious disproportion in the production of certain well-defined types of goods. Therefore, monetary measures can never prevent the crisis. It is not over-saving but under-saving which is responsible for the collapse; it is not under-consumption but, in a sense, over-consumption which leads to a scarcity of capital and brings about the end of the boom.

In order to show this in detail, Professor SPIETHOFF distinguishes four categories of goods: (i) goods for current consumption (food, clothing, etc); (2) durable and semi-durable consumption goods such as residential buildings, water supply, electric light installations, gas plants and other public utilities (furniture and motor-cars occupy an intermediate position between (1) and (2)); (3) durable capital goods (fixed capital) such as mines, ironworks, brick and cement factories, textile plants, machine factories, railroads, power plants, etc.; (4) materials required for the construction of durable goods (“goods for indirect or reproductive consumption”), such as iron, steel, cement, lumber, bricks.

It is between the production of these categories of goods, he says, that a disproportion regularly develops during the boom. The result is a situation in which there is shortage and plenty at the same time. As these categories of goods are complementary, a shortage of one category means ipso facto over-production of the other. It is as if one glove of a pair were lost. The one that remains constitutes a useless and unsaleable surplus stock; the missing one represents an actual deficiency.

Over-production of durable goods.

Over-production occurs regularly in the case of durable capital goods, and also in the case of durable consumption goods. This necessarily involves a decrease in demand and over-production of constructional material such as iron, steel, cement, etc.

This discrepancy between demand for, and supply of, durable instruments has its causes on the supply side as well as on the side of the demand. Additions to the capital equipment are paid for out of “capital” (“Erwerbskapital”). Therefore, the production and marketing of durable capital goods (and to a certain extent also of durable consumption goods) must depend on the amount of “capital” which seeks investment. (To-day we should rather say that the demand for such goods is constituted by savings out of income, plus supplements to the flow of saving arising out of various inflationary sources—additional bank credits and hoards of all kinds.) According to Professor SPIETHOFF, the formation of monetary capital (“Erwerbskapital”) tends usually to diminish at the end of the boom for various reasons. Wages rise—which has an adverse effect on the rate of saving; and the increased production encourages the adoption of wasteful methods and leads to losses. Thus the demand for capital equipment falls off.

More important, however, than the decrease in demand is the increase in production and supply. A large proportion of the new capital equipment constructed during the boom is used to produce materials which are required for the further production of such new equipment. So the supply rises progressively in face of a constant or falling demand.

This over-production has been greatly facilitated—or rather, perhaps, made possible—by the development of modern methods of production, which have rendered the production of fixed capital goods largely independent of organic growth. Professor SPIETHOFF refers especially to the substitution of iron, steel and cement for lumber, of mineral coal for charcoal, etc. Contributing factors are furthermore the long interval between the beginning of the construction of plant and factory and the point at which they begin to turn out their products, and the durability of these instruments. (These latter circumstances will be discussed more fully in connection with other theories of the cycle in which they are pivotal.)

Shortage of labour and means of subsistence.

Thus there develops an over-production of producers’ goods and durable consumers’ goods. These are the remaining glove. But where is the missing one? Is not the missing one a purely monetary phenomenon—namely, investible funds which could be supplied by the printing press? No, answers Professor SPIETHOFF. The lack of monetary funds available for investment represents a shortage of physical goods of a certain kind. It becomes impossible to utilise the whole supply of raw material and equipment destined for the construction of more capital equipment and durable consumption goods, for the simple reason that they alone cannot do the job. They could do it only in collaboration with labour and incidentally with means of subsistence for the labourers. A lack of investible funds simply means that these complementary goods are not available. There we have the missing glove. It consists of labour and consumers’ goods.

From this proposition we must draw the conclusion (although Professor SPIETHOFF does not do so himself) that, if the rate of saving did increase—i.e., if some people did refrain from consuming their whole income—the complementary goods would be forthcoming and the boom could continue.

If we have correctly interpreted Professor SPIETHOFFS’ theory,70 his diagnosis of the disequilibrium at the end of the boom is substantially the same as that given by the monetary over-investment school. The allocation of factors of production to the various stages of production does not correspond to the flow of money. The lower stages in the structure of production are under-developed; the higher stages which produce capital goods are over-developed.

Consumers’ goods and capital-goods industries.

It might sound paradoxical that a “lack” of consumers’ goods should be the cause of the breakdown in the capital-goods industries. If there is such a shortage, consumers’ goods industries must flourish. But should not that be a cause for rejoicing rather than for despair to the capital-goods industries? Professor SPIETHOFF does not analyse this objection explicitly. But, obviously, the question must be answered in the same way as it was answered by the monetary over-investment school. If the necessary credit is available and the rate of interest remains low, the prosperity of the consumers’ goods industries will automatically spread to the higher stages, because the latter will then be in a position to compete successfully for the factors of production with the former. If unused factors of production., unemployed labourers, surplus stocks and idle plant) are available and if there are no special causes (e.g., lack of confidence due to political risks) which deter people from investment in spite of profitable opportunities, an all-round increase in production will follow with no rise, or only a slight rise, in prices. If this, however, is not the case, if additional credit is not available and all factors are reasonably well employed, as is the case at the end of the boom, the rate of interest will rise and the capital-goods industries will not be able to retain all the factors which they used to employ: they will be depressed although, or even because, the consumers’ goods industries prosper. (It is not denied that the prosperity of the latter also will soon come to an end, because the difficulties in the capital-goods industries will lead to a destruction of purchasing power and a fall in the demand for consumers’ goods.)

Such a situation is clearly possible, although it looks superficially paradoxical. The phenomenon (alleged to be frequent)71 of consumers’ goods industries feeling the setback of the depression much later than the capital-goods industry is regarded as a verification of the theory. Another question, which will be raised in connection with the discussion of rival theories, is whether this is the only possible outcome of the boom, or whether there is not another cause of the breakdown just as conceivable as a shortage of capital in the sense of a relative over-development of producers’ goods industries, which is again equivalent to under-saving or over-consumption.

The Cassel variant.

Professor CASSEL’S explanation of the collapse of the typical investment boom is much the same as SPIETHOFF’S, although couched in different language and not so fully developed in terms of goods.

In the first phase of the upswing, he says, the increase in production runs parallel to, or is even caused and encouraged by, a corresponding shift in the flow of money. That is to say, there is a strong tendency towards an acceleration of the formation of capital—i.e., an increase in the flow of savings. In the later phases, capital accumulation in this sense slows down, while the production of fixed capital equipment increases. The discrepancy between the flow of money and the trend of production eventually brings about the crisis. “The typical modern trade boom does not mean over-production, or an over-estimate of the demands of the consumers or the needs of the community for the services of fixed capital, but an over-estimate of the supply of capital, or of the amount of savings available for taking over the real capital produced. What is really over-estimated is the capacity of the capitalists to provide savings in sufficient quantity.”72

§ 13.    THE DOWNSWING (DEPRESSION)

Psychological elements.

Professor SPIETHOFF lays great emphasis on the psychological reaction which is bound to come after the excesses of the boom. Pessimism and reluctance to invest and to embark on new enterprises prevail during the depression. The severity and length of the depression depend very much on whether the boom has collapsed with the great detonation of a crisis, financial panic and numerous bankruptcies, or whether it has come to an end gradually, without thunder and lightning—a point much stressed also by Professor PIGOU. Much depends also on the international situation of the country. If the boom was financed from abroad, the consequences of the cessation of capital investments, according to Professor SPIETHOFF, will probably be less severe, because in that case the capital-exporting country has to bear its share of the difficulties and the capital-importing country is to that extent relieved.

The process of contraction also has a cumulative nature. Pessimism and reluctance to invest cause a shrinkage in the volume of purchasing power. Money is hoarded or used to finance losses instead of being invested and spent on producers’ goods. Since savings are not invested, everything that increases the rate of saving (e.g., inequality in the distribution of income) has a depressing influence. (During the upswing the influence is quite the reverse.) Prices fall and this intensifies the prevailing pessimism. There are many other intensifying factors of an institutional nature—e.g., reluctance to reduce prices, especially on the part of industries that are cartellised, and rigidity of wages.

The analysis of these factors, which intensify the depression, has, however, been carried much farther in recent years, especially by English writers belonging to various schools such as KEYNES, PIGOU, ROBBINS, ROBERTSON. At this point of SPIETHOFF’S description the monetary aspects are somewhat neglected.

§ 14.    THE UPTURN (REVIVAL)

Cost adjustments and new investment opportunities.

According to Professors SPIETHOFF and CASSEL, the revival is never brought about by an increase in the demand for consumers’ goods, but always through increased investment. New investments are stimulated by the lowering of construction cost of capital equipment which ensues during the depression as a result of reduction of wages, fall in the price of raw materials, reduction of interest charges, adoption of improved methods of production, etc. Professor CASSEL lays stress on the fall of the rate of interest as exercising an immediate and powerful influence on the value of fixed capital equipment. But on the whole, according to Professor SPIETHOFF—Professor CASSEL is less pessimistic in this respect—these adjustments, which are automatically made during the depression, are not of themselves sufficient to revive the spirit of enterprise and overcome the dead point of the depression. Stronger incentives must come from outside, such as new inventions or discoveries of new markets or good harvests—factors which open out new opportunities for investment and raise the prospective rate of profit. There is now agreement among a great number of students of the subject that the cycles of the nineteenth century were ushered in by discoveries and inventions. In the terminology of the monetary school, it may be said that the discrepancy between the money rate of interest and the profit rate was brought about by a rise in the profit rate rather than by a fall in the money rate.

It would appear that in this respect no hard-and-fast rule can be laid down. If the rate of interest is low and credit plentiful and easily available, the expansion will come sooner or later; but, if a special stimulus appears in the shape of an invention, the opening-up of new territories or the like, the expansion will come earlier and will gather momentum more quickly.

Schumpeter and the rôle of the business pioneer.

Many further details can be, and have been, added to the picture. Psychological and sociological factors can be adduced which may play a rôle in bringing about an acceleration or retardation in the response of entrepreneurs to existing opportunities for profitable investment. The psychological factors will be analysed separately. At this point, however, we may mention the explanation which Professor SCHUMPETER has offered for the fact that innovations appear en masse.73 One must distinguish, he says, between additions to our technological knowledge (that is, inventions which create the possibility of innovations in the productive processes actually employed) on the one hand and the practical introduction of the new methods on the other hand. What matters is not the discovery in the laboratory of a new process but the actual application of a new technique—it may be, a technique the feasibility of which was discovered a long time ago. There is no reason why inventions should not be distributed more or less evenly in time; but there are good reasons for believing that, in practice, new methods come into use in a mass. Only a few business-men have the imaginative power and energy successfully to introduce innovations such as new productive processes for the production of goods already on the market or the introduction of new types of goods, opening-up of new markets, improved methods of marketing and the like. But, while only a few are able to take the lead, many can follow. Once someone has gone ahead and demonstrated the profitability of a “new combination of the factors of production” (as Professor SCHUMPETER puts it), others can easily imitate him. Thus, whenever a few successful innovations appear, immediately a host of others follow them. (While Professor SCHUMPETER’S account of the revival and the description of the cumulative process of expansion fits in perfectly well with Professor SPIETHOFF’S theory, his story of the upper turning-point is quite different and will be considered later.)

§ 15.    RHYTHM AND PERIODICITY

Business mechanism likened to steam-engine.

We may well start the discussion of this section with a famous metaphor from Professor SPIETHOFF’S forerunner—Michael TUGAN-BARANOWSKI.74 TUGAN-BARANOWSKI likens the working of the business-cycle mechanism to that of a steam-engine. “The accumulation of free, loanable capital plays the role of the steam in the cylinder; when the pressure of the steam on the piston attains a certain force, the resistance of the piston is overcome, the piston is set in motion and moves to the end of the cylinder; an opening appears for the steam and the piston recedes to its old position. In the same manner the accumulating free loan capital, after having attained a certain pressure, forces its way into industry, which it sets in motion; it is spent and industry returns to its earlier position.”75

Now the question arises: What corresponds in the business system to the fuel of the steam-engine? Why is it that the cyclical movement goes on and on and never comes to an end? Why do these waves of economic activity not gradually die down like the movement of the steam-engine when no fresh fuel is added? Professor SPIETHOFF’S answer to these questions must be inferred from his theory in general, because he does not put the question explicitly.

Inevitability of the cycle.

The fact that oscillations are large is to be explained by the cumulative nature of the expansion and contraction process, which again is largely due to psychological reactions. Expansion creates optimism which stimulates investment and intensifies expansion. Contraction creates pessimism, which increases contraction. Expansion comes to an end because it is almost impossible to estimate correctly the supply of savings and capital. The construction of capital goods must be undertaken in anticipation of demand, which in turn is constituted by saving and cannot be foreseen correctly. The durability of instruments on the one hand and the length of the construction period on the other make it difficult for supply and demand to keep pace.

The state of depression is interrupted (a) because it creates automatically a situation favourable to the revival of investment, (b) because pessimism disappears with the lapse of time, and (c) because of the introduction of stimuli from outside. Professor SPIETHOFF would probably subscribe to Professor PIGOU’S theory of the mutual generation of errors of optimism and pessimism (which will be discussed later on76).

Professor CASSEL says explicitly that the cyclical movement would gradually die down, if no stimuli were provided from time to time from the outside in the shape of inventions and discoveries.

On the whole, it may be said that the question has not been systematically discussed or satisfactorily answered by the writers of the school under review. But the tenor of the theory suggests an answer in terms of both endogenous and exogenous forces— i.e.,of responses of the economic system to shocks from without.

Re-investment cycles.

There is, however, an idea vaguely indicated at various points in Professor SPIETHOFF’S writings which can be used for the explanation of the regular recurrence of cycles of prosperity and depression. I mean the idea that the massing of the construction of fixed capital equipment at certain dates or during certain short periods of time gives rise to the recurrence of such outbursts of investment, or rather re-investment, in the future, owing to the fact that machinery and other durable equipment installed around a certain date will come up for replacement massed, although probably less densely, around a certain date in the future. This idea that, given an initial boom in capital construction, replacement tends to assume a cyclical pattern, that re-investment moves in cycles, can be traced back to Karl MARX. It has been fully elaborated with all necessary qualifications by Dr. Johan EINARSEN, who has also written its history and has applied the principle to a concrete case with the help of modern statistical devices in his admirable study, Reinvestment Cycles and their Manifestation in the Norwegian Shipping Industry.77

§ 16.    INTERNATIONAL COMPLICATIONS

The question of international complications has not been exhaustively and systematically treated by the theorists of the present group; but it is in principle not very difficult to imagine how the cyclical movement in one country must be assumed, from the point of view of the non-monetary over-investment theory, to influence other countries and to be influenced by international trade conditions. What has been said in this respect in connection with the monetary over-investment theory applies also to the non-monetary version of the over-investment school. It has been mentioned already that the opening of investment opportunities in new territories is considered to have been one of the most potent incentives for the revival of investment during the 19th century.78

C.    Over-investment resulting from Changes in the Demand for Finished Goods: The Principle of Acceleration and Magnification of Derived Demand

§ 17.    INTRODUCTION

Influence of consumers’ demand on investment.

The monetary over-investment theory starts from the discrepancy between the natural and the money rate of interest, and holds monetary factors responsible for the recurrence of over-investment and disequilibrium. The non-monetary branch of the over-investment school emphasises non-monetary factors, technological, changes, innovations and discoveries. The difference between the two types of over-investment theories is not very great: there are intermediate positions, and the two types shade off into each other. They are at one in the belief that the impetus which sets the process of expansion in motion comes from the side of investment and not from that of consumption. Demand for consumers’ goods is, however, affected indirectly by changes in investment; and variations in the demand for consumers’ goods are an important link in the cumulative processes of expansion and contraction. But it has not been sufficiently investigated how changes in consumers’ demand react back on investment.

We have now to discuss an explanation of the business cycle, given by a number of writers, which assigns a leading rôle to changes in the demand for consumers’ goods. It is the proposition that, for technological reasons, slight changes in the demand for consumers’ goods produce much more violent variations in the demand for producers’ goods. This proposition alone does not furnish a complete theory of the business cycle. It must be combined with other relationships between economic variables, and there are various possible schemes into which it can be fitted. It does not necessarily lead to the over-investment theory; and, in fact, the explanations which are built on the acceleration principle are not as a rule classified as over-investment theories. But we shall see that it can easily be combined with the over-investment explanation. The acceleration principle and the over-investment theory as discussed in the preceding pages are in reality not alternative but complementary explanations. The proposition that changes in demand for consumers’ goods are transmitted with increasing intensity to the higher stages of production serves, in conjunction with other factors which have already been mentioned, as an explanation of the cumulative force and self-sustaining nature of the upward movement. It adds an important touch to the picture of the typical business cycle as painted by the over-investment theoreticians. The matter is of the greatest practical importance for the reason that much light is shed on the fact, which in the last few years has been more and more recognised and emphasised, that it is the production of durable goods, of consumers’ goods as well as of capital goods, which fluctuates most violently during the business cycle.

The following authors have developed the acceleration principle—Albert AFTALION,79 BICKERDIKE,80 Mentor BOUNIATIAN,81 T. N. CARVER,82 and MARCO FANNO.83 In recent years, it has been expounded most fully by J. M. CLARK,84 SIMON KUZNETS,85 A. C. PIGOU86 and R. F. HARROD.87 W. C. MITCHELL,88 D. H. ROBERTSON,89 and A. SPIETHOFF90 have incorporated it into their account of the cycle as a contributory factor.91 Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.92

The discussion will proceed in two stages. First, the economic-technological principle will be expounded with the necessary qualifications and amplifications; and secondly the way in which it can be used, within the framework of the over-investment theory, for the explanation of the business cycle will be examined.

§ 18.    STATEMENT OF THE PRINCIPLE

Changes in demand for, and production of, finished goods and services tend to give rise to much greater changes in the demand for, and production of, those producers’ goods which are used for their production. “Finished goods” need not be interpreted in the narrow sense as consumers’ goods, but in a broader sense: goods at any stage are “finished” relatively to the preceding stage of production. The acceleration principle holds, not only for consumers’ goods in respect to the preceding stage, but for all intermediate goods with regard to their respective preceding stages of production. Slight changes in the demand for consumers’ goods may thus be converted into violent changes in demand for goods of a higher order; and, as this intensification tends to work through all stages of production, it is quite natural that fluctuations should be most violent in those stages of production which are farthest removed from the sphere of consumption. It may even happen that a slackening in the rate of growth of demand in one stage is converted into an actual decline in demand for the product of the preceding stage.

Demand for durable goods and commodity stocks.

We can distinguish three cases of the working of the acceleration principle which, as we shall see, can be easily brought under a single formula.

(a)   Durable producers’ goods.—The intensification runs here from changes in demand for the finished goods (which may be durable or perishable) to changes in demand for durable producers’ goods (machines, buildings, etc.) required for the production of the finished article.

(b)   Durable and semi-durable consumption goods such as apartment-houses, automobiles, wireless apparatus, etc. Here the intensification runs from changes in demand for the service (apartments) to changes in demand for the instrument which provides the service (houses).

(c)   Commodity stocks.—Even if there are no individually durable producers’ goods (such as machines), there may be an intensification running from changes in demand for the product to changes in demand for the various goods in process, in cases where a certain stock of these various goods has to be held, the amount of which is relatively fixed in proportion to the magnitude of the output. Such necessary stocks can be regarded as durable in toto, although the parts which constitute the whole are perishable individually.

Monetary aspects.

In order to illustrate the working of the principle, we assume a change in demand for a particular finished article—say for shoes, hats, automobiles—and investigate the influence of this change on derived demand for producers’ goods in the preceding stage. Two very important questions which come at once to the mind will be discussed later, viz.: (1) Where does this first increase in demand originate—i.e., is it due to a switch-over of purchasing power from other uses so that, as the demand for commodity A increases, there is a corresponding decrease in the demand for B, or does it constitute a net increase in aggregate demand out of inflationary sources? Again, (2) How is the induced change in the demand for, and production of, producers’ goods financed? By an expansion of credit or by current savings? Obviously, these problems are closely connected with the problem of the place of the acceleration principle in the theory of the cycle. They will be discussed later. For the moment we shall assume that there is an increase in the demand for particular commodities—wherever this increase comes from—and shall endeavour to explain why the derived demand changes more violently.

§ 19.    ACCELERATION OF DERIVED DEMAND DUE TO THE EXISTENCE OF DURABLE PRODUCERS’ GOODS

Preliminary statement of the principle.

Take the following—static—situation. The value of the yearly output of (say) shoes is 100. The original and replacement cost of the fixed capital equipment—that is, of durable means of production which we shall call “machines”—required for this output is 500, 10% of which must be replaced each year, because the machinery wears out at that rate. In other words, the lifetime of such a machine is ten years. Under this assumption, new machines at the cost of 50 must be constructed each year for replacement.93 Now suppose the demand for shoes rises, so that, if it is to be satisfied, production must be increased by 10% to no a year. If there is no excess capacity and if methods of production are not changed, this increase necessitates an increase of 10% in the stock of fixed capital—that is, an additional production of machinery of 50, which brings the total production of machines from 50 to 100. So an increase of 10% in the demand for, and production of, finished goods necessitates an increase of 100% in the annual production of equipment. The absolute magnification of the change in demand is from 10 to 50; an increase in current production of 10 requires new investment of 50.94

But this increased volume of production of machines can be maintained only if the demand for consumers’ goods goes on rising by the same annual amount of 10. If, in the second year, the increase in demand for shoes slows down to (say) 5, so that the demand for shoes in the second year is 115, the demand for machines will be 75 (50 for replacement and 25 for additional machines). Derived demand has therefore fallen absolutely in consequence of a mere decrease in the rate of increase of the demand for the finished product. Assuming replacement demand constant, derived demand for durable producers’ goods changes with the rate of change—and not with the direction of the absolute change of the final demand; it does not, in other words, depend on whether final demand is rising or falling in an absolute sense.

Replacement demand.

The assumption that replacement demand is constant calls for a quantitative qualification to which Professor FRISCH95 has drawn attention. If capital equipment is being continuously increased by equal amounts per unit of time, the demand for replacement must rise after a while to a new level. In our numerical example, this point would be reached after ten years, when the 50 additional machines of the first year are worn out and must be replaced. If at this point the demand for the finished product ceases to rise, the disappearance of the demand for additional machines will be compensated by the increase in replacement demand. Hence it is not quite correct to say that a decrease in the rate of increase of demand for the finished product must always lead to an actual decrease in the derived demand. It is worthy of note, however, that in each situation (under the conditions assumed) there is one, and only one, state of demand for finished goods—sometimes a rising or falling, sometimes a constant, demand—which will preserve stability in the demand for machines. The exact relationship between the various magnitudes involved could be formulated mathematically.96 We shall see later that a number of restricting and modifying qualifications must be made: it seems hardly worth while therefore at this point to attempt an absolute precision which cannot in any case be maintained in applying the theorem.

Influence of degree of durability.

One point should, however, be clearly realised: and that is the circumstance that the degree of magnification of derived demand depends ceteris paribus upon the durability of the machines. If we assume the service life of the machine to be twice as long—viz., twenty years—the replacement demand for a stock of 500 is only 25 per year. But, if an increase in demand of 10 % for the finished goods supervenes and requires an increase in the stock of equipment of 10%, the total production of machines jumps from 25 to 75—i.e., it is trebled, instead of doubled as in the previous case of a service life of ten years. To go to the other extreme: suppose the service life is zero; that is to say, suppose that there are no durable means of production but only materials and labour. Then, in a static situation in regard to production, there being no permanent stocks, the whole supply of materials must at once be replaced. If the output of the finished article (shoes) is 100, and the material (leather) used for this is 50, the whole amount must be replaced. If the demand for shoes then rises by 10% to 110, the production of leather must rise also by 10% to 55. There is no magnification at all.

The qualifications of the principle which are implicit in our assumptions should be kept in mind. The existence of unused capacity is excluded, and a fixed relationship between output and capital equipment is assumed. These and other qualifications have their counterpart in the other two cases set forth in § 20 and § 21 below, and will be discussed in connection with the combined statement of all three cases.

§ 20.    ACCELERATION OF DERIVED DEMAND IN THE CASE OF DURABLE CONSUMPTION GOODS

Analogy with previous case.

The case of durable consumption goods is perhaps the most important of the three. As an example, take apartment-houses. The situation is exactly analogous to the case of the production of shoes analysed in § 19. We have only to substitute “annual service of the house” for “annual production of shoes”, and “apartment-houses” for “machines used for the production of shoes”. In other words, we can conceive of the durable consumption goods as producing a stream of services.

We start again from a static situation. The annual production of the service (housing accommodation as measured, say, by apartment rent) is 100. The stock of durable goods—that is, of houses—from which this stream of services originates is (say) 1,000, of which 100 (10%) must be replaced each year, corresponding to a durability of ten years. If there is an increase in the demand for apartments of 10%, the number of houses, or rather the amount of dwelling-space, must also be increased by 10%—which means a doubling of the construction of new houses, 100 for replacement and 100 as addition to the existing stock. Thus, an addition to the annual flow of services of 10 necessitates an investment of 100.

The further analysis is exactly the same as in the case of the shoes. The case of less durable goods such as motor-cars may also be analysed in the same way by distinguishing between the flow of services and the durable instrument whose value is a multiple of the value of its annual service. (There is, of course, this important institutional difference that, in the case of dwelling-houses, the ownership of the instrument is usually or frequently divorced from the use of the services, while the consumer of the services of an automobile is, as a rule, the owner of the instrument. The technological principle is not altered by this circumstance; but it has other consequences which will be discussed later.)

Depreciation and running cost.

One important quantitative peculiarity of certain types of durable consumers’ goods may be pointed out at this point. The cost of the final service (annual rent of an apartment) consists of two parts—viz., the contribution of the durable instrument and the running expenses (heating, water, maintenance, etc.). If demand for the service rises, the acceleration principle becomes effective in respect of the first part. The quantitative effect—that is, the absolute magnification of derived demand—depends, other things (especially the durability of the instrument) being equal, upon the relative importance of the two parts. In the case of the dwelling-space, the contribution of the durable instrument (the house) is probably relatively large, say four-fifths of the cost of the total output. In our example of the shoe factory, we assumed that the total output was 100, of which only one half consisted of the contribution of the durable instruments, the other half consisting of materials and labour. Under these assumptions, other things being equal, the absolute magnification of derived demand is much greater in the case of an increase in the demand for apartments than in the case of an equal increase in the demand for shoes. If the demand for shoes rises from 100 to 110, the demand for machines rises from 50 to 100. If the demand for apartments rises from 100 to 110, the demand for houses rises from 80 to 160.

§ 21.    ACCELERATION OF DERIVED DEMAND AS A RESULT OF THE EXISTENCE OF PERMANENT STOCKS OF GOODS

Analogy with previous cases.

Even if there are no durable means of production, there may be a certain magnification of derived demand, if distributors and producers hold stocks in a fixed (or relatively fixed) proportion to the rate of sales or production. The assumption that the stock bears a fixed proportion to the rate of sales or to output is the counterpart of the assumption that there is a fixed relationship between output and machines.

Let us start again with a static situation, say, with a monthly sale of 100,000 pairs of shoes. Suppose that dealers usually hold permanent stocks equal in magnitude to the sales of one month and that demand and sales rise to 110,000 and the increase is believed to be lasting. Dealers will then increase their orders with producers by more than their sales have gone up in order to bring their stocks up to the usual ratio to sales. They will order 120,000 pairs; but the larger orders will be maintained only if sales go on rising. If the increase in sales ceases at the end of one month, even though there is no decrease, stocks will no longer be augmented and orders for producers will fall to 110,000 (although not to the original level of 100.000).

The principle works, however, in the other direction as well. If the demand for shoes falls off, dealers will reduce stocks and their orders will therefore fall by more than the amount by which their sales have decreased. Derived demand fluctuates more violently.

Some qualifications.

Although from the formal mathematical point of view the parallelism between the case of stocks and the case of fixed capital is complete, the case of the stocks presents some quantitative peculiarities, the consequence of which is to imply much more drastic qualifications and reservations in the application of the principle. (1) The assumption of a comparatively fixed relationship between sales and stocks is much more precarious, and subject to more serious and frequent exceptions, than the corresponding assumption as to the fixity of the ratio between output and capital equipment. Stocks can be easily diminished or increased: they can be consumed rapidly, and are therefore subject to speculative changes. (2) The durability is smaller than in the case of fixed equipment. Hence replacement demand responds much more rapidly to an increase in output and sales in the case of stocks than in the case of machines. If new machinery with a service life of ten years is installed, its installation does not affect replacement demand until after ten years. If sales go up and stocks are increased correspondingly, replacement demand rises in the succeeding period.

For these reasons, the stocks factor is less likely to exhibit clearly the acceleration of derived demand than the fixed capital factor.

§ 22.    GENERALISED STATEMENT OF THE PRINCIPLE

In all three cases which have been distinguished, the relevant circumstance is that, in order to increase the rate of output, it is usually necessary to make heavy immediate investments in the shape of stocks or—what is in practice much more important—in fixed capital, the fruits of which investments mature only in the more or less distant future.

The same thing can be put in another way. The durability of instruments makes it necessary to provide all at once for future demand over a considerable period. The supply required to satisfy the demand for any given period to come must be produced immediately and stored up in the shape of stocks and durable instruments.

If we assume that there is a periodic up-and-down movement in the demand for a finished article as represented by a sine curve, the movement in the requirements for the capital equipment has to be represented by a steeper curve of the same type. This derived curve, which represents the effect, will usually show a lead vis-à-vis its cause. It will reach the high points and low points before the causal curve. This is a rather paradoxical situation, because one would expect the cause to precede the effect and not the effect the cause. But the dominant factor is, with certain qualifications which have been made above (§ 19), not the direction of the change (the mere fact that demand for the finished product is rising or falling absolutely), but the rate of change, or changes in the rate of change, in the demand for the finished product.

§ 23.    QUALIFICATIONS

Limited application in negative sense.

We spoke of changes in “the requirements for capital equipment”. If we want to substitute for this “demand” for, or “production” of, capital goods, we must consider that demand and production cannot become negative.97 As soon as the production of capital goods falls to zero—the demand for the finished product continuing to decline—excess capacity will develop; and, when demand for the finished product rises again, the production of capital goods will not be resumed until after the accumulated surplus has been absorbed. So long as there is unused capacity (or dealers are overstocked),98 the acceleration principle of derived demand will not come into play.

Variable proportions of factors.

Excess capacity has been excluded by the assumption that there is a constant ratio between rate of output on the one hand and capital equipment and stocks on the other. In reality, this ratio is not constant, even apart from inventions and improvements in the technique of production which allow an increase in output per unit of capital equipment. Existing, capital equipment may be utilised more or less intensively; Overtime can be worked or more hands can be engaged. Nor is this all. If demand for the product rises and new machinery has to be installed, the durability of the new equipment may be different. Whether more or less durable machines are employed, whether more or less fixed capital is combined with a given amount of labour and circulating capital, depends among many other things on the rate of interest and the rate of wages and on the general outlook, that is the expectations entertained by producers about the future development of wages, interest and other cost items on the one hand and the future state of demand on the other.

This raises very fundamental questions, and it might be well to reflect once more on the essential nature of the principle.

In its more rigorous form, it postulates a certain quantitative relationship between the production of finished goods and that of their means of production. In a less ambitious form, taking all qualifications into consideration, it simply says that an increase in demand for, and production of, consumers’ goods tends to stimulate investment and that a fall in the former tends to affect the latter adversely.

Various interrelations between consumption and investment.

In this less ambitious sense, its validity can hardly be doubted. It should, however, be noted that this does not preclude the possibility of (a) there being causal connections between the production of consumers’ goods and investment of a different sort than the one postulated by our principle and even operating in the opposite direction in certain cases,99 and (b) the production of capital goods (investment) being influenced, not only by changes in the demand for consumers’ goods, but by other factors as well. It may perhaps be said that any investment, directly or indirectly, is looking forward to, and is made in the expectation of, a future demand for consumers’ goods. But, as Professor HANSEN has pointed out,100 there are types of investment which look forward for their utilisation to a very distant future—e.g., the opening up of a new region by the construction of a railroad. In such cases, the connection between the investment and the present state and recent movement of the demand for consumers’ goods is very slender. Long-run expectations determine investment decisions of this sort, and the influence of the current output of finished goods on these expectations can hardly be assumed to follow a uniformly defined quantitative pattern.101

Besides these adventurous kinds of investments, there are other investments, in working and fixed capital, which follow more or less closely the ups and downs of consumers’ demand—routine investments one might call them. It is with these that the acceleration principle in its more rigorous form is concerned.

§ 24.    THE CONTRIBUTION OF THE PRINCIPLE OF DERIVED DEMAND TO THE EXPLANATION OF THE GENERAL BUSINESS CYCLE

Reciprocal action of consumers’ demand and capital production.

It has sometimes been assumed that, in order to utilise the acceleration principle for the explanation of the general business cycle, one has to presuppose a cyclical alternation of expansion and contraction in consumers’ demand.102 The acceleration principle then serves to explain the larger fluctuations in the capital-goods industries. The situation is, however, much more involved, because consumers’ demand and capital production (investment) interact on one another.

In order to throw light on this inter-relation, the two questions which have been raised above and reserved for later discussion must now be dealt with.

Nature of the initial impulse.

Where does the increase in the demand for the f finished product come from? Two cases have to be distinguished, viz.: (a) the case of a net increase in aggregate demand due to a monetary change, an increase in the quantity of money, dishoarding or an increase in the velocity of circulation; and (b) the case of a mere shift in demand from one commodity or group of commodities to another.

Ad (a).   If an (inflationary) increase in the aggregate demand for finished goods in terms of money takes place, the acceleration principle is sufficient explanation of the marked stimulation experienced in the higher stages of production. Demand for capital goods rises, and this involves a rise in demand for bank credit. The profit rate rises, and our principle reveals an important factor which makes for progressive expansion and adds to the cumulative force of the upswing.

Ad (b).   The situation is rather different where there has been no rise in aggregate income, but only a shift in demand from commodity A to commodity B. Demand for capital goods derived from A falls, demand derived from B rises. Do not these two changes cancel each other out, so that, on balance, activities in industries producing producers’ goods will not be stimulated? The answer is that they may cancel out, but that there is not only no necessity for them to do so but even a probability against it. It is likely that in many cases a net increase in demand for producers’ goods will result.

Factors affecting the outcome.

The outcome will mainly depend on three circum stances: first, on the relative importance and durability of fixed capital in the production of A and B; secondly, on the existence or non-existence of unused capacity and on the relative magnitude of the same in the two industries; thirdly, on whether and to what extent the machinery used for the production of A can also be used for the production of B.

If, in the production of B (say automobiles), the demand for which has risen, fixed capital plays a more important rôle, and a more durable equipment is needed than in the production of A (say textiles) where demand has fallen, then this shift in demand for finished goods will induce a considerable increase in the demand for capital goods.

But, even if the proportion of fixed to working capital and the durability of the former is the same for A and B, it is quite possible that the shift in demand from A to B will create a net increase in demand for fixed capital (provided the machinery producing A is such that it cannot be used for the production of B). The principle of acceleration of derived demand works in both directions, as we know. But, in the downward direction, its operation is limited by the fact that production cannot fall below zero. If, therefore, in the case of a shift of demand from A to B, the demand for machinery producing A falls to zero, this loss may very well be more than compensated by an increase in the demand for new equipment producing B.103

The net result of a shift in the demand for finished products on the demand for capital goods will be lessened, if machinery producing A can be used without alteration, or with only slight alterations, for the production of B. It is very likely that, in some higher stage, the two streams of production, traced backward from A and B, coincide. The steel industry, for example, is common to a number of industries besides A and B—e.g., railway construction and the building industry. Obviously, it makes a great difference whether the production processes of A and B coincide in (say) the second, or only in the fifth, stage of production. If the two commodities A and B are far removed from one another in the sphere of production, only a small part of the fixed capital devoted to the production of A can be used for the production of B; and so in the event of a shift of demand from A to B, any increase in the demand for new equipment and for the materials needed to construct it will be comparatively strong.

Method of financing the new investment

Two alternatives are open for discussion. The new investments can be financed (a) by means of current savings or (b) by way of inflation through the creation of new bank credit and/or more intensive utilisation of existing means of payment. In other words, the increased investment may or may not be consistent with the maintenance of the stability of the monetary circulation—i.e., of MV.

Ad (a).   Suppose that, with the working of the acceleration principle, a shift or an increase in the aggregate demand for finished goods affords new investment opportunities, but that the supply of capital in terms of money is not increased by way of inflation. There is no elastic credit supply, and no hoards of any sort which producers can draw on. The consequence will be a rise in the rate of interest. This will produce a retrenchment of investment—of reinvestment or new investment, as the case may be—in different branches of industry, offsetting the increased investment in industries in which the demand for the finished product has risen. The aggregate demand for producers’ goods cannot therefore rise.

Ad (b).   It is of course recognised by the leading exponent of the acceleration principle, Professor J. M. CLARK, that the principle cannot serve as an explanation of the business cycle, nor even as an incomplete and partial explanation, except in conjunction with an elastic credit supply. Unless it entails a credit expansion, an increase in investment in particular branches of industry cannot produce a general up-turn in business activity. If there has been an increase in the circulating medium, income and demand for finished goods will rise; this will further stimulate investment, and so a cumulative process of expansion will be started.

The acceleration principle is thus assimilated by the over-investment theory, and adds an important feature to the picture of the cycle as drawn in the preceding sections.

Further considerations.

Closer analysis reveals further points of connection between the acceleration principle and the over-investment theory.

The fact that durable instruments are required in order to satisfy current demand for finished goods or services may be characterised, in the terminology of the monetary over-investment theory, as an incentive to the initiation of roundabout methods of production. The more durable the instrument, the longer the roundabout methods of production.

It has been mentioned already that the durability of the instruments, and the amount invested in them in response to an increase in demand for a finished product, cannot be taken as economic constants, determined solely and rigidly by the state of technological knowledge. As a rule, there are various methods of production to choose between; and more or less durable equipment can be installed, the more durable varieties being more costly. (Less durable instruments which cost as much as their more durable rivals are, of course, ruled out as uneconomical from the beginning.) The choice between these depends mainly on the rate of interest. The lower the rate the more durable the instrument and the longer the roundabout process of production. There is, furthermore, the risk factor. In an atmosphere of optimism and confidence, people will be more inclined to undertake heavy investments than in a state of uncertainty and fear. Also the rapidity of replacement of existing equipment, and therefore the length of its service life, will be influenced by these factors.

The production of durable consumers’ goods may give rise to credit expansion no less than the production of durable producers’ goods. If demand for apartments rises, the construction of houses may be undertaken with the help of inflationary bank credit. In the case of semi-durable goods, such as automobiles, where it is usually the instrument (and not only the service) that is bought by the last consumer out of his income, an instalment purchase scheme may enable consumers to extend their current purchases beyond their current income. Thus a slight increase in the income which allows its recipient to increase current consumption may bring about a much larger increase in demand in general.

Naturally, not only an actual, but also an anticipated, increase in demand for a finished product may bring about an increase in investment many times as large as the expected annual increase in demand for the finished product.

All these considerations bring out the importance of the rôle played by the acceleration principle in the mechanism of expansion as described by over-investment theorists.

After the upward movement has been started, the acceleration principle explains the rapid absorption of unused factors of production in the upper stages of production. Naturally, the principle cannot work unobstructed after all the factors, or particular types of the factors, of production have become fully employed. But these questions have been discussed above in connection with the monetary over-investment school.

Causes of the breakdown.

The nature of the cumulative process of expansion having been thus explained, there remain various possibilities of explaining the collapse of the boom. One explanation is that sooner or later a shortage of capital in the previously defined sense arises.

It has been pointed out above that a decrease in the rate of increase of demand for a finished product (say railway lines) need not entail an actual decrease in demand for, and production of, producers’ goods (say steel). It is possible that the decrease in new demand will be compensated by an increase in replacement demand. If the construction of new railway lines decreases only after a long period, the steel industry need not experience any decline at all. Whether this condition can be fulfilled depends to a large extent (but not wholly) on the availability of capital. If a shortage of capital develops, railway construction must be curtailed and the steel industry will suffer a decline in demand. We observe here again a close interrelation between the over-investment theory and the acceleration principle.

But shortage of capital is not the only conceivable explanation of the breakdown. Professor AFTALION, who is amongst the exponents of the acceleration principle, has put forward the theory that the turning-point comes, not because the new investments cannot be completed owing to a shortage of capital, but, on the contrary, after the new roundabout processes of production (construction of durable instruments) have been completed and begin to pour out consumers’ goods. Prices fall; consumers’ goods industries become depressed; and this depression is transmitted with increasing violence to the higher stages of production.

This line of thought will be discussed again in connection with under-consumption theories.

A somewhat different standpoint in this matter is taken up by Professor RÖPKE, who has recently laid great stress on the acceleration principle as affording an explanation of why a serious breakdown is unavoidable after a period of rapid expansion.104 His analysis of the rôle of the acceleration principle in the mechanism of expansion is the same as that which is given above. He does not, however, explain the ensuing breakdown by the emergence of capital shortage or of an insufficiency of consumers’ demand: nor does he believe that the breakdown can be avoided by more saving (as the capital shortage theorists do) or by more spending (as the under-consumption theorists do). He believes that, owing to the operation of the acceleration principle, a situation in the structure of production is bound to develop which can under no circumstances be maintained—either by less saving on the part of the public or by more—so that a serious breakdown is inescapable. According to him, this type of maladjustment is unavoidable after a period of rapid capital accumulation, even in a planned socialist economy of the Russian type.

But how, it may be asked, does he describe this maladjustment from which there is no escape except through a more or less severe crisis? “It is the steep rise of the absolute amount of investments which matters, not the fact that our economic system must rely on credit expansion to make this rise possible.”105 And again: “The scale of investment grows, and so long as the rate at which it grows remains constant, or even increases, the boom has the power to last. Eventually, however, the moment must come when investment is not suddenly broken off certainly, but ceases to grow at the previous rate. We cannot always be building and ‘rationalising’ further, always constructing new electricity works, etc.—especially as the power of the credit system to go on continually financing this investment delirium is finally exhausted. At this point, the boom must come to an end, since the shrinkage of the capital goods industries is unavoidable.”106

These quotations do not make the situation envisaged by our author perfectly clear;107 but it is the nearest we can get to his meaning. In the second part of this book (see § 5 of Chapter II) it is proposed to work out a situation which perhaps covers what Professor RÖPKE really has in mind.

 

 

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108 Naturally, other groupings are possible, but that selected seems to be the most natural and useful.

109 Monetary Theory and the Trade Cycle, London, 1933 (translated from the German). Prices and Production, London, 1931, enlarged edition, 1934. See also his latest exposition, “Preiserwartungen, monetäre Schwankungen und Fehlinvestitionen” in Nationalokonomisk Tidskrift, 1935 (translated into French: “Prévision de prix, perturbations monétaires et faux investissements” in Revue des Sciences économiques, 1936).

110 Börsenkredit, Industriekredit und Kapitalbildung, Vienna, 1931.

111 The Theory of Money and Credit, London, 1934 (translated from the German). Geldwertstabilisierung und Konjunkturpolitik, Jena, 1928.

112 The Great Depression, London, 1934.

113 Crises and Cycles, London, 1936 (translated from the German). “Trends in German Business Cycle Policy”, Economic Journal, September 1933.

114 Kapital und Produktion, Vienna, 1934.

115 Interest and Prices, London, 1936, translated from the German, Geldzins und Güterpreise, Jena, 1898; Lectures on Political Economy, London, 1934, Vol. II, translated from the Swedish; “The Influence of the Rate of Interest on Prices”, Economic Journal, June 1907. On the evolution of Wicksell’s theory, see the excellent introduction by Professor B. Ohlin to Interest and Prices. Compare also the elaboration of Wicksell’s theory by recent Swedish writers as summarised in Professor G. Myrdal’s paper “Der Gleichgewichtsbegriff als Instrument der geldtheoretischen Analyse” in Beiträge zur Geldtheorie, ed. by HAYEK, 1933, and E. Lundberg, Studies in the Theory of Economic Expansion, London, 1937. Some aspects of the theory and their history have been discussed at great length by A. W. Marget, The Theory of Prices, Vol. I, Ch. VII-X. In Vol. II, which has not yet appeared, the discussion will be continued.

116 Vorlesungen über Nationalökonomie, Vol. II, page 220. It is possible to trace in Wicksell’s writings an alternative definition of the natural rate—viz., as that rate which would prevail in a barter economy where loans are made in natura. This conception presents, however, great theoretical difficulties. We shall therefore disregard it.

117 Inasmuch as money loaned out is supposed to be used for productive purposes (that is to say, is invested), we can also say that the equilibrium rate is that rate at which savings—voluntary savings as distinct from “forced savings”—become equal to investment. If the market rate is below the equilibrium rate, investments exceed savings: if it is above, investments fall short of savings. Saving, in this context, has not to be interpreted according to the unusual definition adopted by Mr. Keynes in the Treatise on Money, and later discarded by him in the General Theory of Employment, Interest and Money. Mr. Keynes now employs a definition of saving according to which aggregate saving is only another aspect of aggregate investment, both being defined as the difference between the money value of output and expenditure on consumption. This is not the sense, however, in which saving is used by the authors now under consideration. For them, additions to the value of current output do not immediately constitute disposable income; and it is thus open to them to regard saving as something different from investment. When they say that investment exceeds saving, they mean that there is in progress an inflationary increase in the money value of output which is not immediately translated into increased incomes. When they say that investment falls short of current saving, they mean that there is in progress a process of hoarding, a deflationary decrease in the money value of output. Which terminology is the more convenient—whether it is better to regard saving as necessarily equal to investment or not—is at present still an open question which will he discussed at some length in Chapter 8, below.

118 Cf. Brinley Thomas, “The Monetary Doctrines of Professor Davidson” in Economic Journal, Vol. 45, 1935, pages 36 et seq., and F. A. HAYEK, Monetary Theory and the Trade Cycle, passim.

119 Independently from WICKSELL, Mr. Hawtrey introduced the notion of the “natural rate” (which he distinguished from the “profit rate”) in his first book Good and Bad Trade (London, 1913). But, since he did not use this concept in any of his later writings, we have made no reference to it in the summary of his theory. The concept of a “natural rate” (and even the term) can be found in earlier English economic writings.

120 See the latest version of his theory in The Theory of Interest, New York, 1930, Chapter II. The first version was contained in his Appreciation and Interest (1896). Cf. also Adarkar, “Fisher’s Real Rate Doctrine” in Economic Journal, Vol. 44,1934, page 337, and Professor D. H. Robertson, “Industrial Fluctuations and the Natural Rate of Interest”, ibid., pages 650 et seq.

121 As Professor Hansen has pointed out, many of these concepts must be interpreted as referring to “expected” rather than to “contemporary” magnitude. It is the “expected” profit or yield from capital investment which must be set against the money rate of interest. Fairness to the older writers demands this interpretation, even if they frequently failed to emphasise “expectations” to the extent which has since become fashionable.

122 It should be remembered that the present theory has been developed independently of Mr. Hawtrey’s. Whether and to what extent they have historically a common origin in the Marshallian tradition and earlier English and Continental writers will not be discussed here.

123 Intermediate goods and consumers’ goods are measured in value units. Since we are concerned with a proportion of values, we are not bothered by the objection that there can be no common measure for valuations at different time points. The problem of the “time-dimension” of capital has given rise to endless disputes, especially in recent years. We shall, however, refrain from going more closely into the matter, since, the theories at present under discussion can be analysed without a final decision on this point. (Cf. Nicholas Kaldor: “Annual Survey of Economic Theory: The Recent Controversy on the Theory of Capital” in Econometrica, Vol. V, 1937, page 201 et seq, the reply by F. H. Knight and rejoinder by N. Kaldor, loc. cit., Vol. VI, 1938. See also Hugh Gaitskell: “Notes on the Period of Production”, Zeitschrift für Nationalökonomie, Vol. 7, 1936, and Vol. 9, 1938.)

124 Cf., e.g., Bresciani-Turroni: “The Theory of Saving”, in Economica (New Series), Vol. 3, 1936, pages 1 et seq., and 162 et seq.

125 It 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).

126 The 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).

127 Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.

128 Banking Policy and the Price Level, 1932 ed., page 48.

129 Industrial Fluctuations, 1929, page 141.

130 See 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.

131 Since 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.

132 Such 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.

133 This 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.

134 HAYEK: Prices and Production, 2nd ed., London, 1934, page 57.

135 These paper profits are also likely to add to the cumulative force of the upswing, because they stimulate borrowers and lenders to borrow and lend more. They foster the optimistic spirit prevailing during the upswing, and so the credit expansion is likely to be accelerated. This phenomenon has its exact counterpart during the downswing of the cycle. See the excellent analysis of this phenomenon by E. Schiff, Kapitalbildung und Kapitalaufzehrung im Konjunkturverlauf (1933), esp. Ch. IV, pages 113-134; also Fr. Schmidt, Die Industriekonjunktur—ein Rechenfehler (1927), who has tried to build a complete theory of the cycle on this factor.

136 In 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).

137 A. H. Hansen and H. Tout, in “Investment and Saving in Business Cycle Theory,” Econometrica, April 1933, have pointed out the underlying assumptions.

138 If competition in the labour market and the mobility of labour are imperfect, the condition of full employment can, of course, be relaxed.

139 The fact that the production of consumers’ goods can be expanded only at the expense of a reduction in the production of producers’ goods and vice versa does not, of course, hold if there are idle factors of production available. Furthermore, it does not preclude the possibility that, besides this physical connection between the production of the two categories of goods, there may be connections of another nature—e.g., an increase in the production of consumers’ goods may tend to stimulate the production of producers’ goods, as postulated by the “acceleration principle” (see below, § 17 et seq. of this chapter), or there may be a causal connection in the opposite direction as postulated by the so-called “multiplier” (see below, passim).

140 The proposition therefore does not apply during depression when there are unemployment, unused plant in almost all branches of industry, and a plentiful supply of credit.

141 The 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.

Compare H. S. Ellis, German Monetary Theory 1905-1933 (1934), pages 425-431, on other views on “The ‘Productivity’ of Bank Credit”.

142 2nd ed., pages 55 et seq.

143 Ibid., page 57.

144 Ibid., page 58.

145 “Monetary Expansion and the Structure of Production” in Social Research, Vol. I, New York, November 1934, pages 434 et seq. Similar objections had been raised by Piero Sraffa, Economic Journal, March 1932.

146 Hayek: “Capital and Industrial Fluctuations” in Econometrica, Vol. II, April 1934, page 161. Reprinted as Appendix to 2nd ed. of Prices and Production. See also E. F. M. Durbin: Purchasing Power and Trade Depression, London, 1933, pages 153-155. The latter concludes that the crisis is a purely monetary phenomenon, brought about by the refusal of the banks to continue the expansion of credit.

147 Hayek, op. cit., pages 160 and 161.

148 Mr. Durbin argued that if the rate of increase of production is constant (say 10% per year) an increasing amount of money can be put into circulation without raising prices, because the absolute increase in output per unit of time increases (the 10% is reckoned from an are ever-increasing total). Evidently, different quantitative assumptions can be made, and it is impossible to say which one corresponds best to reality. For further comments on the failure of the writers of the present school to make their assumptions quantitatively precise, see the following paragraph.

149 Cf. C. Bresciani-Turroni, “The Theory of Saving” in Economica, 1936, pages 165 et seq.

150 The following statement of a prominent adherent of the monetary over-investment theory is significant: “This theory does not make the pretence of being the only explanation of all cycles and crises that have ever occurred, nor does it pretend that it states unconditional necessities” (F. Machlup, “Professor Knight and the ‘Period of Production’” in Journal of Political Economy, Vol. 43, October 1935, page 622.

151 See especially L. Robbins: The Great Depression, London, 1934.

152 See: Crises and Cycles, London, 1936 (translated from the German). “Geldtheorie und Weltkrise” in Deutscher Volkswirt of September 25th, 1931. “Praktische Konjunkturpolitik” in Weltwirtschaftliches Archiv, 34. Band, 1931. “Trends in German Business Cycle Policy” in Economic Journal, September 1933.

153 See, in particular: Keynes: A Treatise on Money, London, 1930. Robertson: Banking Policy and the Price Level, and the controversy in Economic Journal of the following dates: Robertson, “Mr. Keynes’ Theory of Money”, September 1931; Keynes, “A Rejoinder to Mr. Robertson”, September 1931; Robertson, ‘‘Saving and Hoarding”, September 1933, and three notes on “Saving and Hoarding”, by Keynes, Hawtrey and Robertson, December 1933.

154 Kapital und Produktion, Vienna, 1934, pages 208 et seq.

155 See especially L. Robbins: The Great Depression, London, 1934.

156 On this subject, compare M. W. Holtrop: De Omloopssnelheid van het geld, Amsterdam, 1928, and “Die Umlaufsgeschwindigkeit des Geldes” in Beiträge zur Geldtheorie, ed. by Hayek, Vienna, 1933, pages 115-211. Compare further J.Marschak: “Volksvermögen und Kassenbedarf” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 68, 1932, pages 385-419, and “Vom Grössensystem der Geldwirtschaft,” loc. cit., Vol. 69, 1933, pages 492-504. H. Neisser: Der Tauschwert des Geldes, Jena, 1928. “Der Kreislauf des Geldes” in Weltwirtschaftliches Archiv, 1931, Vol. 33, pages 365-408. “Volksvermögen und Kassenbedarf “in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 69, 1933, pages 484-492. A. W. Marget: “A Further Note on Holtrop’s Formula for the ‘Coefficient of Differentiation’ and Related Concepts” in Journal of Political Economy, Vol. 41, pages 237-241 and “The Relation between the Velocity of Circulation of Money and the Velocity of Circulation of Goods”, loc. cit., Vol. 40, 1932, pages 289-313 and 477-512. J. Schumpeter: “Das Sozialprodukt und die Rechenpfennige” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 44, pages 627-715. The whole literature on this subject is well reviewed and summarised by Professor H. S. Ellis, German Monetary Theory 1905-1933 (Cambridge, Mass., 1934), Part II, and by A. W. Marget, The Theory of Prices. A Re-examination of the Central Problems of Monetary Theory, Vol. I, New York, 1938, passim.

157 In the earlier versions of the theory, the assumption was made, more or less explicitly, that the discrepancy between the equilibrium rate and money rate of interest is always brought about by a lowering of the money rate—that is, from the supply side. It is now pretty generally accepted that the situation is more complex and that the equilibrium rate is likely to move upward under the influence of psychological forces, price changes, inventions and discoveries, etc.

158 Strigl, op. cit., Anhang I. It may be added that, owing to the existence of the various reserves which will have been accumulated during the depression, the expansion can go far with little or no help from the banks.

159 Professor Hayek in particular has laid down the methodological rule that the analysis of the cyclical movement should never start on the assumption of existing unemployment, because that would beg the question of why unemployment can exist at all. This postulate would seem to narrow down unduly and quite unnecessarily the scope of such analyses.

160 See, however, Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 172-174.

161 Geldwertstabilisierung und Konjunkturpolitik, Jena, 1928, pages 56-61.

162 Compare Professor H. Neisser’s criticism in his article: “Notenbankfreiheit?” in Weltwirtschaftliches Archiv, Vol. 32, pages 446-461, and Vera Smith, The Rationale of Central Banking, London, 1936.

163 See his book, Börsenkredit Industriekredit und Kapitalbildung, Vienna, 1931, pages 161-178.

164 Whilst there can be little doubt that we have here a possible source of inflation (whatever its quantitative importance), it is difficult to see in this factor any independent cyclical significance.

165 Therefore, the statement made in the text is perfectly compatible with the free-trade argument. The qualifications made should be sufficient to exclude protectionist measures from the arsenal of a rational depression policy.

166 See especially R. Nurkse: Internationale Kapitalbewegungen, Vienna, 1935. Ch. V, pages 187-211.

167 We need not go into the causes which give a country an advantage in the production of this or that type of goods. They range from climatic conditions and the quality of the soil to the structure of the tariff and social legislation. Cf. B. Ohlin, Interregional and International Trade, passim, Cambridge, Mass. (U.S.A.), 1933.

168 Cf. Durbin: The Problem of Credit Policy, 1935; Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 175 and 176.

169 See “Vorbemerkungen zu einer Theorie der Ueberproduktion” in Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft, 1902. “Krisen” in Handwörterbuch der Staatswissenschaften, 1925.

170 See Theory of Social Economy, revised ed., London, 1932, Vol. II (translated from the German).

171 See Les Crises industrielles en Angleterre, Paris, 1913 (translated from the Russian). For further references, see A. H. Hansen, Business Cycle Theory, 1927, Ch. IV.

172 Cf., e.g., the highly interesting analysis of the cyclical movement on the basis of the Cassel-Spiethoff theory by Professor Georg Halm in his article “Das Zinsproblem am Geld- und Kapitalmarkt” in Jahrbücher für Nationalökonomie und Statistik, Vol. 125, 1926, pages 1-34 and 97-121.

173 See, e.g., The Downfall of the Gold Standard, Oxford, 1936. Like Mr. Hawtrey, he believes that “the economic development of post-war times has been so strikingly dominated by great monetary disturbances that trade cycles of the earlier kind are no longer applicable” (The Theory of Social Economy, Vol. II, page 538).

174 See Spiethoff’s article “Krisen” in the Handwörterbuch der Staatswissenschaften, Vol. VI, 4th ed., Jena, 1925, page 49.

175 G. Cassel: The Theory of Social Economy, revised ed., London, 1932, page 552.

176 Op. cit., page 74.

177 See the penetrating critical analysis by Professor G. Halm (loc. cit., pages 30-34).

178 Recent statistical studies have made it very doubtful whether such a lag actually exists. Compare, e.g., Professor J. Tinbergen in Statistical Testing of Business-Cycle Theories II. Business cycles in the United States, 1919-1937. In preparation.

179 The Theory of Social Economy, Vol. II, page 649.

180 See The Theory of Economic Development, Cambridge, Mass., 1934. (Translated from the German. The first German edition was published in 1911.) It must, however, be noted that Professor Schumpeter puts forward this theory, not as an explanation of the lower turning-point, but of the movement of the system away from equilibrium. He believes that it is possible to divide the upswing as well as the downswing in two sharply distinguishable phases: a movement towards equilibrium called revival and recession respectively, and a movement away from equilibrium, prosperity (or boom) and depression. Revival and prosperity constitute the upswing, recession and depression the downswing. The recuperative forces of adjustment inherent in the economic system are sufficient, so Professor Schumpeter believes, to lift output and employment from the subnormal level to which it has been reduced by the vicious spiral of deflation during the depression phase; no special incentives are needed to explain the lower turning-point. Professor Schumpeter’s “genial entrepreneur” and the crowd of imitators who follow him come in later during the upswing and prevent the system from settling down for any length of time at an equilibrium position.

Serious objections can be raised against this view. But the idea that the system passes through an equilibrium, or at least approaches a normal position, somewhere between the upper and the lower turning-point seems to have been vaguely envisaged by many writers. It will be clearly elaborated in Professor Schumpeter’s forthcoming volume on the business cycle. It may be added that the fact that Professor Hayek starts his analysis from an equilibrium position seems to indicate rather a methodological principle than the proposition that the system actually passes through an equilibrium position on its way from the lower to the upper turning-point.

181 Studien für Geschichte der Handelskrisen in England, Jena, 1901.

182 Loc. cit., page 251.

183 See Chapter 6, § 2, page 148 below.

184 Published by the University Institute of Economics, Oslo, 1938. See also article by the same author, “Reinvestment Cycles” in the Review of Economic Statistics, Vol. 20, February 1938.

185 This idea is fundamental to the Neo-Marxian theory of Imperialism of such writers as Rosa Luxemburg, Akkumulation des Kapitals, and Fritz Sternberg, Imperialismus (1928). For a brief review, criticism and references to this literature compare H. Neisser, Some International Aspects of the Business Cycle, Philadelphia, 1936, pages 161-172.

186 Les crises périodiques de surproduction, Paris, 1913.

187 “A Non-monetary Cause of Fluctuations in Employment” in Economic Journal, September 1914.

188 Les crises économiques, Paris, 1922; 2nd ed., 1930.

189 “A Suggestion for a Theory of Industrial Depressions” in Quarterly Journal of Economics, May 1903.

190 Beiträge zur Geldtheorie, ed. by Hayek.

191 “Business Acceleration and the Law of Demand” in Journal of Political Economy, March 1917. Economics of Overhead Costs, Chicago, U.S.A., 1923. Controversy with Ragnar Frisch in Journal of Political Economy, October and December 1931, April 1932. Strategic Factors in Business Cycles, New York, 1934, pages 33 et seq.

192 “Relations between Capital Goods and Finished Products in the Business Cycle” in Economic Essays in Honour of Wesley Clair Mitchell, New York, 1935.

193 Industrial Fluctuations, 2nd ed., 1929, Ch. IX.

194 The Trade Cycle, Oxford, 1936, Ch. II.

195 Business Cycles, 1913.

196 A Study of Industrial Fluctuation, London, 1915, Part I, Ch. 2. Banking Policy and the Price Level, 3rd improved ed., London, 1932, Ch. 2.

197 “Krisen” in Handwörterbuch der Staatswissenschaften, 1925.

198 Compare also the critical discussion of the principle by J. Tinbergen, “Statistical Evidence on the Acceleration Principle” in Economica, Vol. V (New Series), May 1938, pages 164-176. Professor Tinbergen does not find much statistical evidence, but this is not surprising in view of the many qualifications which must be made (see below in the text).

199 This would not seem to be a fortunate terminology, because, apart from the relation between consumption and investment which is postulated by the acceleration principle, there are relations between the two magnitudes of another kind (see below).

200 A continuous replacement presupposes, of course, that the existing capital stock has been constructed in a continuous series of instalments. If that is not the case, replacement will be also discontinuous. “Replacement waves” may ensue, if the construction of the capital stock proceeds by fits and starts.

201 This statement is somewhat simplified for purposes of exposition. It is here tacitly assumed that the demand for, and supply of, the finished product jumps suddenly at the beginning of a new year to the extent of 10 per annum. Simultaneously, new machines must be available to the extent of 50, which, added to the replacement output of 50 per annum, brings the total machine output for the year to 100. It would be more realistic perhaps to suppose that the rise in demand comes about gradually and evenly in the course of the year. In this case the machine output would, as before, be 100 (i.e. an increase of 50 over the year before the expansion began); but the augmentation of the output of the finished product would amount only to 10/2=5. It is further assumed that machines retain their productive efficiency unimpaired throughout their lifetime.

202 “The Inter-relation between Capital Production and Consumer Taking” in Journal of Political Economy, Vol. 39, October 1931, page 646. See also the subsequent discussion between Frisch and J. M. Clark in Vols. 39 and 40 of Journal of Political Economy. Pigou has already made sufficient allowance for this quantitative qualification in his formulation of the acceleration principle in his Industrial Fluctuations, Ch. IX.

203 See the above-mentioned article by Frisch.

204 This point has been well put by Professor J. Tinbergen. In the article mentioned on page 87, he says:

“In its more rigorous form, the acceleration principle can only be true if the following conditions are fulfilled.

“(a) Very strong decreases in consumers’ goods production must not occur. If the principle were right, they would lead to a corresponding disinvestment and this can only take place to the extent of replacement. If annual replacement amounts to 10% of the stock of capital goods, then a larger decrease in this stock than 10% per annum is impossible. A decrease in consumers’ goods production of 15% could not lead to a 15% decrease in physical capital as the acceleration principle would require. It is interesting that this limit is the sharper the greater the duration of life of the capital goods considered.”

205 The term “unused capacity” must be interpreted with great care. There is always some inferior capacity which can handle an increase of demand.

206 Compare e.g., § 4 of this chapter, page 45 above.

207 See his criticism of Harrod’s rather unqualified utilisation of the acceleration principle in The Quarterly Journal of Economics, Vol. 51, May 1937, pages 509 et seq. (now reprinted in Full Recovery or Stagnation, New York, 1938).

208 This has also been well put by Professor D. H. Robertson. “. . . Some of the principal forms of investment in the modern world—the instruments of power-production, of transport, of office activity—are, after all, very loosely geared to the visible demand for particular types of consumption goods and depend rather on fairly vague estimates of the future progress of whole areas and populations. (See his review of Harrod’s The Trade Cycle in The Canadian Journal of Economics and Political Science, Vol. III, 1937, page 126.)

209 Criticism by C. O. Hardy before the American Statistical Association, December 1931. Quoted by J. M. Clark in Journal of Political Economy, October 1932, page 693.

210 It follows that the expansionary effect of. a shift in the demand is more likely to be great if it occurs during a period when the demand for equipment in both industries is at a relatively low level. If it takes place while a general expansion is in progress, the acceleration principle has free play to operate in both directions and the effects on industry A and B are therefore more likely to compensate each other.

211 Crises and Cycles (1936), pages 102 et seq. See also his article “Socialism, Planning and the Business Cycle” in Journal of Political Economy, Vol. 44, June 1936. A similar analysis is to be found in R. G. Harrod, The Trade Cycle, Oxford (1936), page 165 and passim.

212 Crises and Cycles, page 110.

213 Crises and Cycles, page 102.

214 It is not clear whether he has visualised the theoretical possibility of replacement demand’s stepping into the shoes of new investment in such wise as to bring about a smooth transition to a stationary equilibrium.

• 1Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.
• 2See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.
• 3See his book: Strategic Factors in the Business Cycle, passim.
• 4The Lessons of Monetary Experience, page 131.
• 5Ibid., page 131, and Monetary Reconstruction, page 133.
• 6Capital and Employment, page 86.
• 7Kapital und Produktion, Vienna, 1934.
• 8What 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.
• 9For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 10This 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.
• 11Op. cit., page 171.
• 12Trade and Credit, London, 1928, page 98.
• 13Currency and Credit, 3rd ed., London, 1928, page 153.
• 14Cf. 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.
• 151913, page 186.
• 16Monetary Reconstruction, 2nd ed., London, 1926, page 135.
• 17See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
• 18It 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).
• 19The 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).
• 20Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.
• 21Banking Policy and the Price Level, 1932 ed., page 48.
• 22Currency and Credit, 3rd ed., page 155.
• 23See 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.
• 24Since 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.
• 25Such 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.
• 26This 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.
• 27HAYEK: Prices and Production, 2nd ed., London, 1934, page 57.
• 28See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
• 29In 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).
• 30A. H. Hansen and H. Tout, in “Investment and Saving in Business Cycle Theory,” Econometrica, April 1933, have pointed out the underlying assumptions.
• 31If competition in the labour market and the mobility of labour are imperfect, the condition of full employment can, of course, be relaxed.
• 32The fact that the production of consumers’ goods can be expanded only at the expense of a reduction in the production of producers’ goods and vice versa does not, of course, hold if there are idle factors of production available. Furthermore, it does not preclude the possibility that, besides this physical connection between the production of the two categories of goods, there may be connections of another nature—e.g., an increase in the production of consumers’ goods may tend to stimulate the production of producers’ goods, as postulated by the “acceleration principle” (see below, § 17 et seq. of this chapter), or there may be a causal connection in the opposite direction as postulated by the so-called “multiplier” (see below, passim).
• 33No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
• 34The 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.
• 352nd ed., pages 55 et seq.
• 36Ibid., page 57.
• 37Ibid., page 58.
• 38“Monetary Expansion and the Structure of Production” in Social Research, Vol. I, New York, November 1934, pages 434 et seq. Similar objections had been raised by Piero Sraffa, Economic Journal, March 1932.
• 39Hayek: “Capital and Industrial Fluctuations” in Econometrica, Vol. II, April 1934, page 161. Reprinted as Appendix to 2nd ed. of Prices and Production. See also E. F. M. Durbin: Purchasing Power and Trade Depression, London, 1933, pages 153-155. The latter concludes that the crisis is a purely monetary phenomenon, brought about by the refusal of the banks to continue the expansion of credit.
• 40Hayek, op. cit., pages 160 and 161.
• 41Mr. Durbin argued that if the rate of increase of production is constant (say 10% per year) an increasing amount of money can be put into circulation without raising prices, because the absolute increase in output per unit of time increases (the 10% is reckoned from an are ever-increasing total). Evidently, different quantitative assumptions can be made, and it is impossible to say which one corresponds best to reality. For further comments on the failure of the writers of the present school to make their assumptions quantitatively precise, see the following paragraph.
• 42Cf. C. Bresciani-Turroni, “The Theory of Saving” in Economica, 1936, pages 165 et seq.
• 43The following statement of a prominent adherent of the monetary over-investment theory is significant: “This theory does not make the pretence of being the only explanation of all cycles and crises that have ever occurred, nor does it pretend that it states unconditional necessities” (F. Machlup, “Professor Knight and the ‘Period of Production’” in Journal of Political Economy, Vol. 43, October 1935, page 622.
• 44See especially L. Robbins: The Great Depression, London, 1934.
• 45See: Crises and Cycles, London, 1936 (translated from the German). “Geldtheorie und Weltkrise” in Deutscher Volkswirt of September 25th, 1931. “Praktische Konjunkturpolitik” in Weltwirtschaftliches Archiv, 34. Band, 1931. “Trends in German Business Cycle Policy” in Economic Journal, September 1933.
• 46See, in particular: Keynes: A Treatise on Money, London, 1930. Robertson: Banking Policy and the Price Level, and the controversy in Economic Journal of the following dates: Robertson, “Mr. Keynes’ Theory of Money”, September 1931; Keynes, “A Rejoinder to Mr. Robertson”, September 1931; Robertson, ‘‘Saving and Hoarding”, September 1933, and three notes on “Saving and Hoarding”, by Keynes, Hawtrey and Robertson, December 1933.
• 47Kapital und Produktion, Vienna, 1934, pages 208 et seq.
• 48See especially L. Robbins: The Great Depression, London, 1934.
• 49On this subject, compare M. W. Holtrop: De Omloopssnelheid van het geld, Amsterdam, 1928, and “Die Umlaufsgeschwindigkeit des Geldes” in Beiträge zur Geldtheorie, ed. by Hayek, Vienna, 1933, pages 115-211. Compare further J.Marschak: “Volksvermögen und Kassenbedarf” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 68, 1932, pages 385-419, and “Vom Grössensystem der Geldwirtschaft,” loc. cit., Vol. 69, 1933, pages 492-504. H. Neisser: Der Tauschwert des Geldes, Jena, 1928. “Der Kreislauf des Geldes” in Weltwirtschaftliches Archiv, 1931, Vol. 33, pages 365-408. “Volksvermögen und Kassenbedarf “in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 69, 1933, pages 484-492. A. W. Marget: “A Further Note on Holtrop’s Formula for the ‘Coefficient of Differentiation’ and Related Concepts” in Journal of Political Economy, Vol. 41, pages 237-241 and “The Relation between the Velocity of Circulation of Money and the Velocity of Circulation of Goods”, loc. cit., Vol. 40, 1932, pages 289-313 and 477-512. J. Schumpeter: “Das Sozialprodukt und die Rechenpfennige” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 44, pages 627-715. The whole literature on this subject is well reviewed and summarised by Professor H. S. Ellis, German Monetary Theory 1905-1933 (Cambridge, Mass., 1934), Part II, and by A. W. Marget, The Theory of Prices. A Re-examination of the Central Problems of Monetary Theory, Vol. I, New York, 1938, passim.
• 50In the earlier versions of the theory, the assumption was made, more or less explicitly, that the discrepancy between the equilibrium rate and money rate of interest is always brought about by a lowering of the money rate—that is, from the supply side. It is now pretty generally accepted that the situation is more complex and that the equilibrium rate is likely to move upward under the influence of psychological forces, price changes, inventions and discoveries, etc.
• 51Strigl, op. cit., Anhang I. It may be added that, owing to the existence of the various reserves which will have been accumulated during the depression, the expansion can go far with little or no help from the banks.
• 52Professor Hayek in particular has laid down the methodological rule that the analysis of the cyclical movement should never start on the assumption of existing unemployment, because that would beg the question of why unemployment can exist at all. This postulate would seem to narrow down unduly and quite unnecessarily the scope of such analyses.
• 53See, however, Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 172-174.
• 54Geldwertstabilisierung und Konjunkturpolitik, Jena, 1928, pages 56-61.
• 55Compare Professor H. Neisser’s criticism in his article: “Notenbankfreiheit?” in Weltwirtschaftliches Archiv, Vol. 32, pages 446-461, and Vera Smith, The Rationale of Central Banking, London, 1936.
• 56See his book, Börsenkredit Industriekredit und Kapitalbildung, Vienna, 1931, pages 161-178.
• 57Whilst there can be little doubt that we have here a possible source of inflation (whatever its quantitative importance), it is difficult to see in this factor any independent cyclical significance.
• 58Therefore, the statement made in the text is perfectly compatible with the free-trade argument. The qualifications made should be sufficient to exclude protectionist measures from the arsenal of a rational depression policy.
• 59See especially R. Nurkse: Internationale Kapitalbewegungen, Vienna, 1935. Ch. V, pages 187-211.
• 60We need not go into the causes which give a country an advantage in the production of this or that type of goods. They range from climatic conditions and the quality of the soil to the structure of the tariff and social legislation. Cf. B. Ohlin, Interregional and International Trade, passim, Cambridge, Mass. (U.S.A.), 1933.
• 61Cf. Durbin: The Problem of Credit Policy, 1935; Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 175 and 176.
• 62See “Vorbemerkungen zu einer Theorie der Ueberproduktion” in Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft, 1902. “Krisen” in Handwörterbuch der Staatswissenschaften, 1925.
• 63See Theory of Social Economy, revised ed., London, 1932, Vol. II (translated from the German).
• 64See Les Crises industrielles en Angleterre, Paris, 1913 (translated from the Russian). For further references, see A. H. Hansen, Business Cycle Theory, 1927, Ch. IV.
• 65Cf., e.g., the highly interesting analysis of the cyclical movement on the basis of the Cassel-Spiethoff theory by Professor Georg Halm in his article “Das Zinsproblem am Geld- und Kapitalmarkt” in Jahrbücher für Nationalökonomie und Statistik, Vol. 125, 1926, pages 1-34 and 97-121.
• 66See, e.g., The Downfall of the Gold Standard, Oxford, 1936. Like Mr. Hawtrey, he believes that “the economic development of post-war times has been so strikingly dominated by great monetary disturbances that trade cycles of the earlier kind are no longer applicable” (The Theory of Social Economy, Vol. II, page 538).
• 67See Spiethoff’s article “Krisen” in the Handwörterbuch der Staatswissenschaften, Vol. VI, 4th ed., Jena, 1925, page 49.
• 68G. Cassel: The Theory of Social Economy, revised ed., London, 1932, page 552.
• 69Op. cit., page 74.
• 70See the penetrating critical analysis by Professor G. Halm (loc. cit., pages 30-34).
• 71Recent statistical studies have made it very doubtful whether such a lag actually exists. Compare, e.g., Professor J. Tinbergen in Statistical Testing of Business-Cycle Theories II. Business cycles in the United States, 1919-1937. In preparation.
• 72The Theory of Social Economy, Vol. II, page 649.
• 73See The Theory of Economic Development, Cambridge, Mass., 1934. (Translated from the German. The first German edition was published in 1911.) It must, however, be noted that Professor Schumpeter puts forward this theory, not as an explanation of the lower turning-point, but of the movement of the system away from equilibrium. He believes that it is possible to divide the upswing as well as the downswing in two sharply distinguishable phases: a movement towards equilibrium called revival and recession respectively, and a movement away from equilibrium, prosperity (or boom) and depression. Revival and prosperity constitute the upswing, recession and depression the downswing. The recuperative forces of adjustment inherent in the economic system are sufficient, so Professor Schumpeter believes, to lift output and employment from the subnormal level to which it has been reduced by the vicious spiral of deflation during the depression phase; no special incentives are needed to explain the lower turning-point. Professor Schumpeter’s “genial entrepreneur” and the crowd of imitators who follow him come in later during the upswing and prevent the system from settling down for any length of time at an equilibrium position.
• 74Studien für Geschichte der Handelskrisen in England, Jena, 1901.
• 75Loc. cit., page 251.
• 76See Chapter 6, § 2, page 148 below.
• 77Published by the University Institute of Economics, Oslo, 1938. See also article by the same author, “Reinvestment Cycles” in the Review of Economic Statistics, Vol. 20, February 1938.
• 78This idea is fundamental to the Neo-Marxian theory of Imperialism of such writers as Rosa Luxemburg, Akkumulation des Kapitals, and Fritz Sternberg, Imperialismus (1928). For a brief review, criticism and references to this literature compare H. Neisser, Some International Aspects of the Business Cycle, Philadelphia, 1936, pages 161-172.
• 79Les crises périodiques de surproduction, Paris, 1913.
• 80“A Non-monetary Cause of Fluctuations in Employment” in Economic Journal, September 1914.
• 81Les crises économiques, Paris, 1922; 2nd ed., 1930.
• 82“A Suggestion for a Theory of Industrial Depressions” in Quarterly Journal of Economics, May 1903.
• 83Beiträge zur Geldtheorie, ed. by Hayek.
• 84“Business Acceleration and the Law of Demand” in Journal of Political Economy, March 1917. Economics of Overhead Costs, Chicago, U.S.A., 1923. Controversy with Ragnar Frisch in Journal of Political Economy, October and December 1931, April 1932. Strategic Factors in Business Cycles, New York, 1934, pages 33 et seq.
• 85“Relations between Capital Goods and Finished Products in the Business Cycle” in Economic Essays in Honour of Wesley Clair Mitchell, New York, 1935.
• 86Industrial Fluctuations, 2nd ed., 1929, Ch. IX.
• 87The Trade Cycle, Oxford, 1936, Ch. II.
• 88Business Cycles, 1913.
• 89A Study of Industrial Fluctuation, London, 1915, Part I, Ch. 2. Banking Policy and the Price Level, 3rd improved ed., London, 1932, Ch. 2.
• 90“Krisen” in Handwörterbuch der Staatswissenschaften, 1925.
• 91Compare also the critical discussion of the principle by J. Tinbergen, “Statistical Evidence on the Acceleration Principle” in Economica, Vol. V (New Series), May 1938, pages 164-176. Professor Tinbergen does not find much statistical evidence, but this is not surprising in view of the many qualifications which must be made (see below in the text).
• 92This would not seem to be a fortunate terminology, because, apart from the relation between consumption and investment which is postulated by the acceleration principle, there are relations between the two magnitudes of another kind (see below).
• 93A continuous replacement presupposes, of course, that the existing capital stock has been constructed in a continuous series of instalments. If that is not the case, replacement will be also discontinuous. “Replacement waves” may ensue, if the construction of the capital stock proceeds by fits and starts.
• 94This statement is somewhat simplified for purposes of exposition. It is here tacitly assumed that the demand for, and supply of, the finished product jumps suddenly at the beginning of a new year to the extent of 10 per annum. Simultaneously, new machines must be available to the extent of 50, which, added to the replacement output of 50 per annum, brings the total machine output for the year to 100. It would be more realistic perhaps to suppose that the rise in demand comes about gradually and evenly in the course of the year. In this case the machine output would, as before, be 100 (i.e. an increase of 50 over the year before the expansion began); but the augmentation of the output of the finished product would amount only to 10/2=5. It is further assumed that machines retain their productive efficiency unimpaired throughout their lifetime.
• 95“The Inter-relation between Capital Production and Consumer Taking” in Journal of Political Economy, Vol. 39, October 1931, page 646. See also the subsequent discussion between Frisch and J. M. Clark in Vols. 39 and 40 of Journal of Political Economy. Pigou has already made sufficient allowance for this quantitative qualification in his formulation of the acceleration principle in his Industrial Fluctuations, Ch. IX.
• 96See the above-mentioned article by Frisch.
• 97This point has been well put by Professor J. Tinbergen. In the article mentioned on page 87, he says:
• 98The term “unused capacity” must be interpreted with great care. There is always some inferior capacity which can handle an increase of demand.
• 99Compare e.g., § 4 of this chapter, page 45 above.
• 100See his criticism of Harrod’s rather unqualified utilisation of the acceleration principle in The Quarterly Journal of Economics, Vol. 51, May 1937, pages 509 et seq. (now reprinted in Full Recovery or Stagnation, New York, 1938).
• 101This has also been well put by Professor D. H. Robertson. “. . . Some of the principal forms of investment in the modern world—the instruments of power-production, of transport, of office activity—are, after all, very loosely geared to the visible demand for particular types of consumption goods and depend rather on fairly vague estimates of the future progress of whole areas and populations. (See his review of Harrod’s The Trade Cycle in The Canadian Journal of Economics and Political Science, Vol. III, 1937, page 126.)
• 102Criticism by C. O. Hardy before the American Statistical Association, December 1931. Quoted by J. M. Clark in Journal of Political Economy, October 1932, page 693.
• 103It follows that the expansionary effect of. a shift in the demand is more likely to be great if it occurs during a period when the demand for equipment in both industries is at a relatively low level. If it takes place while a general expansion is in progress, the acceleration principle has free play to operate in both directions and the effects on industry A and B are therefore more likely to compensate each other.
• 104Crises and Cycles (1936), pages 102 et seq. See also his article “Socialism, Planning and the Business Cycle” in Journal of Political Economy, Vol. 44, June 1936. A similar analysis is to be found in R. G. Harrod, The Trade Cycle, Oxford (1936), page 165 and passim.
• 105Crises and Cycles, page 110.
• 106Crises and Cycles (1936), pages 102 et seq. See also his article “Socialism, Planning and the Business Cycle” in Journal of Political Economy, Vol. 44, June 1936. A similar analysis is to be found in R. G. Harrod, The Trade Cycle, Oxford (1936), page 165 and passim.
• 107It is not clear whether he has visualised the theoretical possibility of replacement demand’s stepping into the shoes of new investment in such wise as to bring about a smooth transition to a stationary equilibrium.
• 108The 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.
• 109It 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.
• 110With 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).
• 111In 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.
• 112In 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.
• 113He 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”.
• 114The theories of the following writers will now be examined: F. A. HAYEK, F. MACHLUP, L. MISES, L. ROBBINS, W. RÖPKE and R. STRIGL. The explanation given by these writers of the upswing and of the down-turn (crisis) is fundamentally the same. Such differences as exist are mainly in respect of amplifications in the later publications. Serious conflicts of opinion are to be found, on the other hand, in respect of the description and explanation of the downswing and the up-turn (revival). Professor RÖPKE, in particular, dissents strongly from the opinion of the other writers named in the interpretation of the later phases of such prolonged depressions as that of 1929-1936. The writers of this group have this in common with the purely monetary theory of Mr. HAWTREY, that they assume an elastic money supply. They argue that the circulating medium consists under modern conditions primarily of bank money (deposits), and that the banking system regulates the quantity of money by changing the discount rate and by conducting open-market operations. It has long been recognised that there is a complicated functional relationship between the interest rate, changes in the quantity of money and the price level. These relationships have been expounded systematically by KNUT WICKSELL; his theory, outlined below, is the basis of the explanation of the business cycle which follows. It should be added that, in what follows, we shall leave international complications for the moment out of account and disregard the fact that a change in the interest rate in one country will influence the flow of credit from and to other countries. These complications can easily be introduced into the picture later. For the present, we presuppose a closed economy.
• 115One 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.
• 116One 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.
• 117The 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).
• 118“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.”
• 119“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.”
• 120The 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.”
• 121In 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.
• 122In 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.
• 123But 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”.
• 124To 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.
• 125If 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.
• 126This 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.
• 127Treatment 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.
• 128Apart, 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.”
• 129Under 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”.
• 130Professor 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.
• 131But 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.
• 132Furthermore, 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.
• 133The 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.
• 134An 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.
• 135With 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.
• 136There 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.
• 137It 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.
• 138It 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.
• 139It 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.
• 140A 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.
• 141If 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.
• 142In 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.
• 143In 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.
• 144In 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.
• 145But, as Professor NEISSER has shown, there is no reason to expect this return to the old arrangement, if the new roundabout methods of production have been brought to completion. When they are completed, the flow of consumers’ goods which was temporarily reduced will rise again, and will even reach a higher level than that from which the expansion started, so that consumers can safely expand their consumption. Forced saving will cease to be necessary when the new processes of production are completed. When they are completed, all that is required to maintain them is that the entrepreneurs—not the consumers—should refrain from “disinvestments”, that is, from consuming capital or from spending amortisation quotas on consumption. There is no reason why the old proportion between money spent for consumers’ and for producers’ goods should be restored. It is not true that the whole of newly injected money becomes income either at once or after a while. Part of it must be retained by the entrepreneurs in order to pay for intermediate goods (in contradistinction to payments for the original factors of production). In other words, only a part of the new money becomes income. Another part remains permanently in the business sphere. It is only if entrepreneurs “dissave”—i.e., if they eat up their capital and refrain from investing that part of their gross receipts which is not net income (working capital and amortisation quotas)—that the pre-inflation arrangement is restored.
• 146It is evident that no collapse would occur if the credit expansion could go on indefinitely. It follows—the point is made by Professor HAYEK himself—that a crisis is equally inevitable in the case of voluntary saving if the flow of saving is suddenly reduced. It is, however, asserted—although the reasons given are not always quite convincing—that sudden changes are not likely to occur in respect of voluntary saving, while forced saving must come to an end abruptly. It is therefore very important to ask why should the expansion of credit stop. The answer is that in a closed economy, leaving out of account purely monetary and institutional factors (inability of the banking system to continue expansion within the limits fixed by the gold standard or some other legal or customary rules), the continuance of the expansion will involve a progressive rise in prices. A progressive rise in prices and the danger of a complete collapse of the monetary system is the only insurmountable barrier which prevents an indefinite continuation of the expansion.
• 147Against this objection, the following argument has been advanced. It is true, in an economy where the output, owing to improvements in the methods of production, grows at a constant rate, that a steady expansion in terms of money may be made: that is to say, per unit of time a constant amount of new money may be put into circulation. But even if this is just enough to keep the price level of finished goods constant, prices of factors of production will rise continuously. Hence, successive additions to the money stock will only be able to buy successively diminishing amounts of the factors of production. But, to render the completion of the newly initiated processes of production possible, the entrepreneurs in the upper stages must be enabled to absorb factors of production àt a constant rate; and, as the prices of factors of production rise, a credit expansion at an increasing rate will be necessary to enable them to do so. The conclusion is that a relative inflation, such as can be made within the limits of a constant price level, is not sufficient to allow of the completion of the new roundabout methods of production which have been initiated under the stimulus of the expansion. Either the rate of expansion of credit will be sufficiently increased and prices will be driven up and the inevitable breakdown will be postponed, or the boom will collapse at once owing to an insufficiency in the capital supply.
• 148Against this objection, the following argument has been advanced. It is true, in an economy where the output, owing to improvements in the methods of production, grows at a constant rate, that a steady expansion in terms of money may be made: that is to say, per unit of time a constant amount of new money may be put into circulation. But even if this is just enough to keep the price level of finished goods constant, prices of factors of production will rise continuously. Hence, successive additions to the money stock will only be able to buy successively diminishing amounts of the factors of production. But, to render the completion of the newly initiated processes of production possible, the entrepreneurs in the upper stages must be enabled to absorb factors of production àt a constant rate; and, as the prices of factors of production rise, a credit expansion at an increasing rate will be necessary to enable them to do so. The conclusion is that a relative inflation, such as can be made within the limits of a constant price level, is not sufficient to allow of the completion of the new roundabout methods of production which have been initiated under the stimulus of the expansion. Either the rate of expansion of credit will be sufficiently increased and prices will be driven up and the inevitable breakdown will be postponed, or the boom will collapse at once owing to an insufficiency in the capital supply.
• 149In any case, the theory in its fully developed form seems to make the emergence of a serious disequilibrium dependent upon relatively small fluctuations in the rate of forced saving. This being so, the question arises whether fluctuations of this order of magnitude are not equally likely to occur in the flow of voluntary savings. If they do occur, evil consequences must be expected, even in the absence of credit inflation. (We shall see, in connection with the discussion of other theories, that there are numerous other disturbances possible which may interrupt the upswing and start a vicious spiral downward—disturbances which are probably of the same, or even of a higher, order of magnitude than the fluctuations in the rate of forced or voluntary saving discussed above.)
• 150To sum up, we may say that the theory has not proved rigorously that a stabilisation of prices in a progressive economy must always lead to over-production, crisis and depression. The practical importance of this conclusion is considerable in view of the American prosperity in the twenties, a notable feature of which was the fact that wholesale prices did not rise.
• 151The theory of the depression is not nearly so fully elaborated by the authors of the monetary over-investment school as the theory of the boom. The depression was originally conceived of by them as a process of adjustment of the structure of production, and was explained in non-monetary terms. During the boom, they argued, the process of production is unduly elongated. This elongation has accordingly to be removed and the structure of production has to be shortened or, alternatively, expenditure on consumers’ goods must be reduced (by retrenchment of wages and other incomes which are likely to be spent wholly or mainly on consumers’ goods) sufficiently to make the new structure of production possible. This involves a lengthy and painful process of rearrangement. Workers are thrown out of work in the higher stages, and it takes time to absorb them in the lower stages of production. In modern times especially, with inflexible wage systems and the various other obstructions represented by all kinds of State intervention, this process of shifting labour and other means of production is drawn out much longer than is necessary for purely technological reasons.
• 152(a)   Professor RÖPKE has studied the question in various publications and has come to the conclusion that the process of deflation has a tendency to become cumulative and self-perpetuating. Genetically, it is true, it is connected with the extravagances of the preceding boom and the real maladjustment which the boom has produced. But the intensity of the deflation by no means necessarily corresponds to the extent of the over-investment. It is also untrue, he believes, that the deflation contributes (as is more or less vaguely suggested by the other authors of the monetary over-investment school) to bringing about the necessary adjustment (shortening) in the process of production. Once started, the deflation is propelled by its own momentum and by a number of institutional factors. What these factors are and how they work, we shall discuss at greater length in another connection. HAWTREY, KEYNES, PIGOU and ROBERTSON have contributed most towards the understanding of this phenomenon.
• 153(a)   Professor RÖPKE has studied the question in various publications and has come to the conclusion that the process of deflation has a tendency to become cumulative and self-perpetuating. Genetically, it is true, it is connected with the extravagances of the preceding boom and the real maladjustment which the boom has produced. But the intensity of the deflation by no means necessarily corresponds to the extent of the over-investment. It is also untrue, he believes, that the deflation contributes (as is more or less vaguely suggested by the other authors of the monetary over-investment school) to bringing about the necessary adjustment (shortening) in the process of production. Once started, the deflation is propelled by its own momentum and by a number of institutional factors. What these factors are and how they work, we shall discuss at greater length in another connection. HAWTREY, KEYNES, PIGOU and ROBERTSON have contributed most towards the understanding of this phenomenon.
• 154The most coherent theory of the depression along these lines is that of Professor STRIGL. He admits that the breakdown of the boom induces a process of hoarding and deflation. After the breakdown of the boom, the banks will not merely stop expansion: they will contract credit in order to increase their liquidity. Under the influence of the general feeling of insecurity and pessimism, industrial firms will also seek to strengthen their cash reserves, and amortisation quotas will be kept in liquid form instead of being invested. This general struggle for liquidity involves hoarding. It means that money, whose function it is to be the vehicle of investment of real capital, fails to fulfil this function and is sterilised for the time being in swollen cash reserves or, in the case of bank money (deposits), annihilated altogether. The general price fall which ensues operates as a further deterrent to investment. The profit rate falls below the money rate. Perhaps the most important external symptom of this process is the intense liquidity and the extremely low rates on the money market which develop during the depression. The low money rates are caused by the fact that the overflow of funds from the money market to the capital market is impeded by an invisible barrier of distrust and pessimism.
• 155It goes without saying that the writers of the group not only admit, but even stress, the fact that the pressure of deflation is intensified and prolonged by all kinds of ill-advised intervention by the State and other public bodies, such as the competitive raising of tariffs, the scramble for gold in order to liquidate existing gold-exchange standards, and all similar measures designed to keep up prices and incomes.
• 156The concept “effective quantity of money” is very complicated. It is not easily defined in theory and is hopelessly difficult to measure statistically. The difficulty comes in principally through the factor “V”. The velocity of circulation meant is not the transaction velocity, nor is it the income velocity. One might perhaps call it trade velocity, the term being understood to cover all transactions which involve an exchange of goods in all stages of production, but to exclude financial transactions (e.g., on the stock exchange). If the quantity and the transaction velocity of money remain constant, but at the same time the requirements of the financial circulation rise, the result will be a decrease in the effective quantity of money as defined above. But these qualifications are not yet sufficient. Allowance must also be made for integration and disintegration of the process of production. If two or more successive stages in a particular line of industry (such as spinning and weaving), which are carried out by independent firms, are integrated by the formation of a vertical trust, the transfer of the intermediate product from the higher to the lower stage, which formerly gave rise to monetary transactions, may in future be effected by mere entries in the books of the new firm. Thus the merger may set free a certain amount of money. The trade velocity of money need not be changed, but the supply of money ought to be restricted; otherwise inflationary consequences will ensue.
• 157The writers of the group under review are, however, well aware of the great danger that the discrepancy between the money rate and the equilibrium rate of interest, which prevailed during the depression, will at once be succeeded by a discrepancy in the opposite direction. In view of the falling prices and the state of pessimism and discouragement, the money rate during the downswing stands above the natural rate. When the fall of prices comes to an end and pessimism gives way to a more optimistic outlook, the current money rates, without being changed, will soon stand below the equilibrium rate. In other words, the equilibrium rate is likely to rise above the money rate. In terms of supply and demand, this can be expressed by saying that the credit demand curve will move to the right or, loosely speaking, that demand will rise. At the same time, the banks will be in a liquid position, and there is every reason to expect that they will liberally comply with the increased demand for credit. The barrier between the money market and the capital market is broken down, and the funds accumulated behind the barrier flow into the investment market.
• 158The writers of the group under review are, however, well aware of the great danger that the discrepancy between the money rate and the equilibrium rate of interest, which prevailed during the depression, will at once be succeeded by a discrepancy in the opposite direction. In view of the falling prices and the state of pessimism and discouragement, the money rate during the downswing stands above the natural rate. When the fall of prices comes to an end and pessimism gives way to a more optimistic outlook, the current money rates, without being changed, will soon stand below the equilibrium rate. In other words, the equilibrium rate is likely to rise above the money rate. In terms of supply and demand, this can be expressed by saying that the credit demand curve will move to the right or, loosely speaking, that demand will rise. At the same time, the banks will be in a liquid position, and there is every reason to expect that they will liberally comply with the increased demand for credit. The barrier between the money market and the capital market is broken down, and the funds accumulated behind the barrier flow into the investment market.
• 159It is convenient at this point to introduce the question of the existence of unused productive resources of all kinds. The explanation given by the writers of the school under review for the upswing, or rather for the boom, almost invariably starts from an equilibrium position with full employment of the means of production. But the argument can easily be adapted to the other case. If there are unemployed resources, evidently the expansion of credit may go on much longer than when all resources are employed. There need, then, be no shift of factors from the lower to the higher stages, but only the absorption of unused resources predominantly in those stages of production which are especially stimulated by the expansion—namely, in the upper stages (capital goods industries). Arguing along the lines of the theory under review, one has to assume that the unemployed resources are mainly put to work in the higher stages (capital-goods industries). But, so long as there is a reserve of unemployed resources, the reaction from excess investment, which consists (as we have seen) of a comparative rise in the demand for consumers’ goods, will not produce a breakdown, since there is no necessity to detach factors of production from the higher stages. Prices need not rise much. The expansion of credit can go on.
• 160This process has never been analysed so closely as the process of expansion starting from a position of full employment. But, applying the same type of reasoning, the conclusion seems to be as follows: A disequilibrium between the higher and the lower stages is produced by the fact that the unemployed resources are not distributed among the different stages of production in the way they ought to be if ultimate equilibrium is to emerge. A larger amount is absorbed into the higher stages than can in the long run be employed there with the given rate of voluntary saving. Thus the recovery from the depth of the depression has a wrong twist from the beginning.
• 161Professor MISES gives the following answer to the question why the cycle of prosperity and depression recurs again and again. The behaviour of the banks is responsible for the occurrence of the business cycle. If the banks did not push the money rate below the natural rate by expanding credit, equilibrium would not be disturbed. But why do the banks make the same mistake again and again? “The answer must be: because the prevailing ideology among business-men and politicians looks on the reduction of the rate of interest as an important aim of economic policy, and because they consider an inflationary expansion of credit the best means to attain that objective” (page 58). “The root cause of the phenomenon that one business cycle follows the other is thus of an ideological nature” (page 60).
• 162Professor MISES believes, furthermore, that the commercial banks alone without the support of the central bank can never produce a dangerous credit inflation, because they would immediately lose cash and become insolvent. It is only with the backing of the central bank that it is possible to expand credit sufficiently to produce a dangerous boom. The ability of the central banks to increase the circulation is due to the monopoly which they hold of the issue of bank-notes. If the issue of notes were not a monopoly, if competition were restored in this field of the central banks’ activities—that is to say, if every bank had the right to issue notes, convertible into legal tender money (gold)—a dangerous expansion of credit and reduction of the interest rate would be impossible. The unsound banks would quickly be eliminated, and the sound banks would learn by experience that expansion is punished by bankruptcy.
• 163Professor MACHLUP has called attention to one factor which helps to explain the recurrence of the cycle and throws into relief the passive rôle of the banks, at any rate during the first phase of the upswing. It is this. A considerable portion of the payments which have to be made during a given period, say a year, are not evenly distributed, but are concentrated at certain dates, some of them at the end of each month and others at the end of each quarter. Therefore, even with the most elaborate clearing and compensation arrangements, no complete continuous offsetting of the debts and liabilities of each firm is possible. At the critical dates, at the end of the month and of the quarter, there is therefore always a strong demand for short-term credit and a resultant strain on the money market. If the banks were not able and willing to relieve this monthly and quarterly tightness of money by granting temporary credits, individual firms would be compelled to provide for their requirements at the critical dates by accumulating cash during the intervals between them. But, as the banks lend money to overcome these difficulties—credit expansion for such a temporary stringency being generally regarded as perfectly legitimate and safe—it is not necessary to accumulate cash, and the sums involved can be invested instead.
• 164It is clear that we have here a source of inflation; and the inflation, according to Professor MACHLUP, will not be confined to the single occasion of the first introduction of these “ultimo loans”, but will tend to recur cyclically. “While the utilisation of temporary surplus cash together with (inflationary) bank credit created the possibility of initiating illicitly long processes of production, the depression, after the elimination of the untenable enterprises, will release these sums again” (pages 175 and 176). During the depression, the investment of these sums is impossible, and they accumulate on the money market; but, as soon as the spirit of enterprise revives, they can be utilised for financing the boom for a long time without any, or with very little, additional bank credit.
• 165Any improvement in the balance of payments—that is to say, any increase in the demand for the means of payment of a given country in terms of the money of other countries—will have an expansionist influence. This improvement may be due to a great variety of circumstances—changes in the demand for particular commodities, crop changes, capital movements, etc. The erection of new tariff walls by an individual country, if not followed by compensatory action on the part of other countries, will have a favourable influence on the international monetary situation of the country which has raised its tariffs. In other words, it will enable the latter to expand its circulation without a deterioration of its exchange rate. Thus, the immediate influence of protectionist measures may be a stimulation of prosperity or an alleviation of depression. But the conditions in which this is true must be borne in mind. If many countries pursue this policy at the same time, the stimulating influence is lost. In the long run, the raising of tariff walls impairs the national dividends of all the countries involved. Indirect effects (e.g., on capital movements) may prevent even the immediate stimulation afforded by protectionist measures. Finally, an improvement in the balance of payments can always be utilised as a means of increasing the gold and foreign-exchange reserve in lieu of expanding the circulation.
• 166In arguing on the basis of the over-investment theory, special attention must be paid to international capital movements. They not only affect the purely monetary situation by stimulating or retarding the expansion or contraction of credit: they have also a bearing on the structure of production. An individual country may finance a boom, wholly or partly, by capital imports from other countries instead of by an internal expansion of credit and forced saving. So long as this is possible, the reaction which the theory under review holds responsible for the breakdown—namely, a corresponding rise in the demand for consumers’ goods—may be staved off. Thus, in so far as a particular country is concerned, the boom may be prolonged. On the other hand, international capital movements are subject to risks and disturbances which are absent in the case of an internal expansion.
• 167An interesting question is how the composition of exports and imports of a country changes during the different phases of the cycle. It might be supposed that capital imports during the upswing are bound to be effected through the import of capital goods. As a general statement, this would, however, be wrong. In any given situation in respect of tariffs or otherwise, what a country imports will depend on the comparative cost situation or, in other words, on the comparative facilities of the various countries for the production of different types of goods. It is conceivable that capital for investment purposes may be imported, not in the shape of capital goods (raw materials, machinery, electrical equipment, etc.), but in the shape of consumers’ goods. This will be the case in a country where capital-goods industries and the production of raw materials are well developed, while consumers’ goods industries are less so.
• 168The most valuable and original contributions of the monetary over-investment theory are (1) the analysis of the maladjustment in the structure of production brought about by the credit expansion during the prosperity phase of the cycle and (2) the explanation of the breakdown as consequent on that maladjustment. But our analysis has also shown that the theory is not in all respects complete. The claim to exclusive validity is open to doubt. It is a little difficult, for example, to understand why the transition to a more roundabout process of production should be associated with prosperity and the return to a less roundabout process a synonym for depression. Why should not the original inflationary expansion of investment cause as much dislocation in the production of consumers’ goods as the subsequent rise in consumers’ demand is said to cause in the production of investment goods?
• 169The most prominent writers in this group are Professors A. SPIETHOFF and G. CASSEL. In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI. Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany, but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.
• 170The most prominent writers in this group are Professors A. SPIETHOFF and G. CASSEL. In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI. Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany, but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.
• 171The most prominent writers in this group are Professors A. SPIETHOFF and G. CASSEL. In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI. Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany, but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.
• 172The most prominent writers in this group are Professors A. SPIETHOFF and G. CASSEL. In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI. Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany, but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.
• 173With regard to Professor CASSEL, it must be remarked that we are here dealing primarily with the theory as expounded in the earlier editions of his Theory of Social Economy. In his later books and especially in his popular writings, he has more or less accepted a purely monetary explanation, at least so far as the 1929-1936 depression is concerned.
• 174Both Professors SPIETHOFF and CASSEL emphatically assert that the business cycle is characterised by changes in the production of capital goods, especially of fixed capital equipment. The production of consumers’ goods does not exhibit the same regularity of change during the business cycle. Professor SPIETHOFF makes the point that upswings have occurred during which consumption has actually fallen. This was the case, according to him, in Germany in the years 1845-1847/48, when the economic situation of the working classes positively deteriorated because of rising food prices due to a series of crop failures. But, even if no account is taken of changes in agricultural production, which are only remotely connected with the ups and downs of industrial production, “the production of consumption goods shows no marked dependence on trade cycles. This means that the alternation between periods of boom and slump is fundamentally a variation in the production of fixed capital, but has no direct connection with the rest of production.”
• 175Both Professors SPIETHOFF and CASSEL emphatically assert that the business cycle is characterised by changes in the production of capital goods, especially of fixed capital equipment. The production of consumers’ goods does not exhibit the same regularity of change during the business cycle. Professor SPIETHOFF makes the point that upswings have occurred during which consumption has actually fallen. This was the case, according to him, in Germany in the years 1845-1847/48, when the economic situation of the working classes positively deteriorated because of rising food prices due to a series of crop failures. But, even if no account is taken of changes in agricultural production, which are only remotely connected with the ups and downs of industrial production, “the production of consumption goods shows no marked dependence on trade cycles. This means that the alternation between periods of boom and slump is fundamentally a variation in the production of fixed capital, but has no direct connection with the rest of production.”
• 176The monetary side of this process is not closely analysed. But Professor SPIETHOFF admits that “credit is an indispensable means to the upswing”. Professor CASSEL is less explicit in this respect. But it can be inferred from various remarks which he lets fall that he realises the necessity for an elastic currency supply. Both writers seem to believe that monetary funds are accumulated during the depression, on which the producers can draw during the upswing to finance the expansion. It follows that no positive steps need be taken by the banking system, at any rate during the first phases of the upswing. It is, however, not denied that, after a certain point, support by the banks is required to carry on. These monetary conditions and the monetary mechanism of credit expansion have been more thoroughly explored by the monetary school. In the writings of Professor ROBERTSON, Mr. KEYNES and Professor PIGOU (all of whom have much in common with SPIETHOFF and CASSEL) will be found the best synthesis of the monetary and non-monetary aspects of the process.
• 177If we have correctly interpreted Professor SPIETHOFFS’ theory, his diagnosis of the disequilibrium at the end of the boom is substantially the same as that given by the monetary over-investment school. The allocation of factors of production to the various stages of production does not correspond to the flow of money. The lower stages in the structure of production are under-developed; the higher stages which produce capital goods are over-developed.
• 178Such a situation is clearly possible, although it looks superficially paradoxical. The phenomenon (alleged to be frequent) of consumers’ goods industries feeling the setback of the depression much later than the capital-goods industry is regarded as a verification of the theory. Another question, which will be raised in connection with the discussion of rival theories, is whether this is the only possible outcome of the boom, or whether there is not another cause of the breakdown just as conceivable as a shortage of capital in the sense of a relative over-development of producers’ goods industries, which is again equivalent to under-saving or over-consumption.
• 179In the first phase of the upswing, he says, the increase in production runs parallel to, or is even caused and encouraged by, a corresponding shift in the flow of money. That is to say, there is a strong tendency towards an acceleration of the formation of capital—i.e., an increase in the flow of savings. In the later phases, capital accumulation in this sense slows down, while the production of fixed capital equipment increases. The discrepancy between the flow of money and the trend of production eventually brings about the crisis. “The typical modern trade boom does not mean over-production, or an over-estimate of the demands of the consumers or the needs of the community for the services of fixed capital, but an over-estimate of the supply of capital, or of the amount of savings available for taking over the real capital produced. What is really over-estimated is the capacity of the capitalists to provide savings in sufficient quantity.”
• 180Many further details can be, and have been, added to the picture. Psychological and sociological factors can be adduced which may play a rôle in bringing about an acceleration or retardation in the response of entrepreneurs to existing opportunities for profitable investment. The psychological factors will be analysed separately. At this point, however, we may mention the explanation which Professor SCHUMPETER has offered for the fact that innovations appear en masse. One must distinguish, he says, between additions to our technological knowledge (that is, inventions which create the possibility of innovations in the productive processes actually employed) on the one hand and the practical introduction of the new methods on the other hand. What matters is not the discovery in the laboratory of a new process but the actual application of a new technique—it may be, a technique the feasibility of which was discovered a long time ago. There is no reason why inventions should not be distributed more or less evenly in time; but there are good reasons for believing that, in practice, new methods come into use in a mass. Only a few business-men have the imaginative power and energy successfully to introduce innovations such as new productive processes for the production of goods already on the market or the introduction of new types of goods, opening-up of new markets, improved methods of marketing and the like. But, while only a few are able to take the lead, many can follow. Once someone has gone ahead and demonstrated the profitability of a “new combination of the factors of production” (as Professor SCHUMPETER puts it), others can easily imitate him. Thus, whenever a few successful innovations appear, immediately a host of others follow them. (While Professor SCHUMPETER’S account of the revival and the description of the cumulative process of expansion fits in perfectly well with Professor SPIETHOFF’S theory, his story of the upper turning-point is quite different and will be considered later.)
• 181We may well start the discussion of this section with a famous metaphor from Professor SPIETHOFF’S forerunner—Michael TUGAN-BARANOWSKI. TUGAN-BARANOWSKI likens the working of the business-cycle mechanism to that of a steam-engine. “The accumulation of free, loanable capital plays the role of the steam in the cylinder; when the pressure of the steam on the piston attains a certain force, the resistance of the piston is overcome, the piston is set in motion and moves to the end of the cylinder; an opening appears for the steam and the piston recedes to its old position. In the same manner the accumulating free loan capital, after having attained a certain pressure, forces its way into industry, which it sets in motion; it is spent and industry returns to its earlier position.”
• 182We may well start the discussion of this section with a famous metaphor from Professor SPIETHOFF’S forerunner—Michael TUGAN-BARANOWSKI. TUGAN-BARANOWSKI likens the working of the business-cycle mechanism to that of a steam-engine. “The accumulation of free, loanable capital plays the role of the steam in the cylinder; when the pressure of the steam on the piston attains a certain force, the resistance of the piston is overcome, the piston is set in motion and moves to the end of the cylinder; an opening appears for the steam and the piston recedes to its old position. In the same manner the accumulating free loan capital, after having attained a certain pressure, forces its way into industry, which it sets in motion; it is spent and industry returns to its earlier position.”
• 183The state of depression is interrupted (a) because it creates automatically a situation favourable to the revival of investment, (b) because pessimism disappears with the lapse of time, and (c) because of the introduction of stimuli from outside. Professor SPIETHOFF would probably subscribe to Professor PIGOU’S theory of the mutual generation of errors of optimism and pessimism (which will be discussed later on).
• 184There is, however, an idea vaguely indicated at various points in Professor SPIETHOFF’S writings which can be used for the explanation of the regular recurrence of cycles of prosperity and depression. I mean the idea that the massing of the construction of fixed capital equipment at certain dates or during certain short periods of time gives rise to the recurrence of such outbursts of investment, or rather re-investment, in the future, owing to the fact that machinery and other durable equipment installed around a certain date will come up for replacement massed, although probably less densely, around a certain date in the future. This idea that, given an initial boom in capital construction, replacement tends to assume a cyclical pattern, that re-investment moves in cycles, can be traced back to Karl MARX. It has been fully elaborated with all necessary qualifications by Dr. Johan EINARSEN, who has also written its history and has applied the principle to a concrete case with the help of modern statistical devices in his admirable study, Reinvestment Cycles and their Manifestation in the Norwegian Shipping Industry.
• 185The question of international complications has not been exhaustively and systematically treated by the theorists of the present group; but it is in principle not very difficult to imagine how the cyclical movement in one country must be assumed, from the point of view of the non-monetary over-investment theory, to influence other countries and to be influenced by international trade conditions. What has been said in this respect in connection with the monetary over-investment theory applies also to the non-monetary version of the over-investment school. It has been mentioned already that the opening of investment opportunities in new territories is considered to have been one of the most potent incentives for the revival of investment during the 19th century.
• 186The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 187The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 188The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 189The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 190The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 191The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 192The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 193The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 194The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 195The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 196The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 197The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 198The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 199The following authors have developed the acceleration principle—Albert AFTALION, BICKERDIKE, Mentor BOUNIATIAN, T. N. CARVER, and MARCO FANNO. In recent years, it has been expounded most fully by J. M. CLARK, SIMON KUZNETS, A. C. PIGOU and R. F. HARROD. W. C. MITCHELL, D. H. ROBERTSON, and A. SPIETHOFF have incorporated it into their account of the cycle as a contributory factor. Mr. HARROD has, without much reference to the previous literature, rechristened the principle as “the Relation”.
• 200Take the following—static—situation. The value of the yearly output of (say) shoes is 100. The original and replacement cost of the fixed capital equipment—that is, of durable means of production which we shall call “machines”—required for this output is 500, 10% of which must be replaced each year, because the machinery wears out at that rate. In other words, the lifetime of such a machine is ten years. Under this assumption, new machines at the cost of 50 must be constructed each year for replacement. Now suppose the demand for shoes rises, so that, if it is to be satisfied, production must be increased by 10% to no a year. If there is no excess capacity and if methods of production are not changed, this increase necessitates an increase of 10% in the stock of fixed capital—that is, an additional production of machinery of 50, which brings the total production of machines from 50 to 100. So an increase of 10% in the demand for, and production of, finished goods necessitates an increase of 100% in the annual production of equipment. The absolute magnification of the change in demand is from 10 to 50; an increase in current production of 10 requires new investment of 50.
• 201Take the following—static—situation. The value of the yearly output of (say) shoes is 100. The original and replacement cost of the fixed capital equipment—that is, of durable means of production which we shall call “machines”—required for this output is 500, 10% of which must be replaced each year, because the machinery wears out at that rate. In other words, the lifetime of such a machine is ten years. Under this assumption, new machines at the cost of 50 must be constructed each year for replacement. Now suppose the demand for shoes rises, so that, if it is to be satisfied, production must be increased by 10% to no a year. If there is no excess capacity and if methods of production are not changed, this increase necessitates an increase of 10% in the stock of fixed capital—that is, an additional production of machinery of 50, which brings the total production of machines from 50 to 100. So an increase of 10% in the demand for, and production of, finished goods necessitates an increase of 100% in the annual production of equipment. The absolute magnification of the change in demand is from 10 to 50; an increase in current production of 10 requires new investment of 50.
• 202The assumption that replacement demand is constant calls for a quantitative qualification to which Professor FRISCH has drawn attention. If capital equipment is being continuously increased by equal amounts per unit of time, the demand for replacement must rise after a while to a new level. In our numerical example, this point would be reached after ten years, when the 50 additional machines of the first year are worn out and must be replaced. If at this point the demand for the finished product ceases to rise, the disappearance of the demand for additional machines will be compensated by the increase in replacement demand. Hence it is not quite correct to say that a decrease in the rate of increase of demand for the finished product must always lead to an actual decrease in the derived demand. It is worthy of note, however, that in each situation (under the conditions assumed) there is one, and only one, state of demand for finished goods—sometimes a rising or falling, sometimes a constant, demand—which will preserve stability in the demand for machines. The exact relationship between the various magnitudes involved could be formulated mathematically. We shall see later that a number of restricting and modifying qualifications must be made: it seems hardly worth while therefore at this point to attempt an absolute precision which cannot in any case be maintained in applying the theorem.
• 203The assumption that replacement demand is constant calls for a quantitative qualification to which Professor FRISCH has drawn attention. If capital equipment is being continuously increased by equal amounts per unit of time, the demand for replacement must rise after a while to a new level. In our numerical example, this point would be reached after ten years, when the 50 additional machines of the first year are worn out and must be replaced. If at this point the demand for the finished product ceases to rise, the disappearance of the demand for additional machines will be compensated by the increase in replacement demand. Hence it is not quite correct to say that a decrease in the rate of increase of demand for the finished product must always lead to an actual decrease in the derived demand. It is worthy of note, however, that in each situation (under the conditions assumed) there is one, and only one, state of demand for finished goods—sometimes a rising or falling, sometimes a constant, demand—which will preserve stability in the demand for machines. The exact relationship between the various magnitudes involved could be formulated mathematically. We shall see later that a number of restricting and modifying qualifications must be made: it seems hardly worth while therefore at this point to attempt an absolute precision which cannot in any case be maintained in applying the theorem.
• 204We spoke of changes in “the requirements for capital equipment”. If we want to substitute for this “demand” for, or “production” of, capital goods, we must consider that demand and production cannot become negative. As soon as the production of capital goods falls to zero—the demand for the finished product continuing to decline—excess capacity will develop; and, when demand for the finished product rises again, the production of capital goods will not be resumed until after the accumulated surplus has been absorbed. So long as there is unused capacity (or dealers are overstocked), the acceleration principle of derived demand will not come into play.
• 205We spoke of changes in “the requirements for capital equipment”. If we want to substitute for this “demand” for, or “production” of, capital goods, we must consider that demand and production cannot become negative. As soon as the production of capital goods falls to zero—the demand for the finished product continuing to decline—excess capacity will develop; and, when demand for the finished product rises again, the production of capital goods will not be resumed until after the accumulated surplus has been absorbed. So long as there is unused capacity (or dealers are overstocked), the acceleration principle of derived demand will not come into play.
• 206In this less ambitious sense, its validity can hardly be doubted. It should, however, be noted that this does not preclude the possibility of (a) there being causal connections between the production of consumers’ goods and investment of a different sort than the one postulated by our principle and even operating in the opposite direction in certain cases, and (b) the production of capital goods (investment) being influenced, not only by changes in the demand for consumers’ goods, but by other factors as well. It may perhaps be said that any investment, directly or indirectly, is looking forward to, and is made in the expectation of, a future demand for consumers’ goods. But, as Professor HANSEN has pointed out, there are types of investment which look forward for their utilisation to a very distant future—e.g., the opening up of a new region by the construction of a railroad. In such cases, the connection between the investment and the present state and recent movement of the demand for consumers’ goods is very slender. Long-run expectations determine investment decisions of this sort, and the influence of the current output of finished goods on these expectations can hardly be assumed to follow a uniformly defined quantitative pattern.
• 207In this less ambitious sense, its validity can hardly be doubted. It should, however, be noted that this does not preclude the possibility of (a) there being causal connections between the production of consumers’ goods and investment of a different sort than the one postulated by our principle and even operating in the opposite direction in certain cases, and (b) the production of capital goods (investment) being influenced, not only by changes in the demand for consumers’ goods, but by other factors as well. It may perhaps be said that any investment, directly or indirectly, is looking forward to, and is made in the expectation of, a future demand for consumers’ goods. But, as Professor HANSEN has pointed out, there are types of investment which look forward for their utilisation to a very distant future—e.g., the opening up of a new region by the construction of a railroad. In such cases, the connection between the investment and the present state and recent movement of the demand for consumers’ goods is very slender. Long-run expectations determine investment decisions of this sort, and the influence of the current output of finished goods on these expectations can hardly be assumed to follow a uniformly defined quantitative pattern.
• 208In this less ambitious sense, its validity can hardly be doubted. It should, however, be noted that this does not preclude the possibility of (a) there being causal connections between the production of consumers’ goods and investment of a different sort than the one postulated by our principle and even operating in the opposite direction in certain cases, and (b) the production of capital goods (investment) being influenced, not only by changes in the demand for consumers’ goods, but by other factors as well. It may perhaps be said that any investment, directly or indirectly, is looking forward to, and is made in the expectation of, a future demand for consumers’ goods. But, as Professor HANSEN has pointed out, there are types of investment which look forward for their utilisation to a very distant future—e.g., the opening up of a new region by the construction of a railroad. In such cases, the connection between the investment and the present state and recent movement of the demand for consumers’ goods is very slender. Long-run expectations determine investment decisions of this sort, and the influence of the current output of finished goods on these expectations can hardly be assumed to follow a uniformly defined quantitative pattern.
• 209It has sometimes been assumed that, in order to utilise the acceleration principle for the explanation of the general business cycle, one has to presuppose a cyclical alternation of expansion and contraction in consumers’ demand. The acceleration principle then serves to explain the larger fluctuations in the capital-goods industries. The situation is, however, much more involved, because consumers’ demand and capital production (investment) interact on one another.
• 210But, even if the proportion of fixed to working capital and the durability of the former is the same for A and B, it is quite possible that the shift in demand from A to B will create a net increase in demand for fixed capital (provided the machinery producing A is such that it cannot be used for the production of B). The principle of acceleration of derived demand works in both directions, as we know. But, in the downward direction, its operation is limited by the fact that production cannot fall below zero. If, therefore, in the case of a shift of demand from A to B, the demand for machinery producing A falls to zero, this loss may very well be more than compensated by an increase in the demand for new equipment producing B.
• 211A somewhat different standpoint in this matter is taken up by Professor RÖPKE, who has recently laid great stress on the acceleration principle as affording an explanation of why a serious breakdown is unavoidable after a period of rapid expansion. His analysis of the rôle of the acceleration principle in the mechanism of expansion is the same as that which is given above. He does not, however, explain the ensuing breakdown by the emergence of capital shortage or of an insufficiency of consumers’ demand: nor does he believe that the breakdown can be avoided by more saving (as the capital shortage theorists do) or by more spending (as the under-consumption theorists do). He believes that, owing to the operation of the acceleration principle, a situation in the structure of production is bound to develop which can under no circumstances be maintained—either by less saving on the part of the public or by more—so that a serious breakdown is inescapable. According to him, this type of maladjustment is unavoidable after a period of rapid capital accumulation, even in a planned socialist economy of the Russian type.
• 212But how, it may be asked, does he describe this maladjustment from which there is no escape except through a more or less severe crisis? “It is the steep rise of the absolute amount of investments which matters, not the fact that our economic system must rely on credit expansion to make this rise possible.” And again: “The scale of investment grows, and so long as the rate at which it grows remains constant, or even increases, the boom has the power to last. Eventually, however, the moment must come when investment is not suddenly broken off certainly, but ceases to grow at the previous rate. We cannot always be building and ‘rationalising’ further, always constructing new electricity works, etc.—especially as the power of the credit system to go on continually financing this investment delirium is finally exhausted. At this point, the boom must come to an end, since the shrinkage of the capital goods industries is unavoidable.”
• 213But how, it may be asked, does he describe this maladjustment from which there is no escape except through a more or less severe crisis? “It is the steep rise of the absolute amount of investments which matters, not the fact that our economic system must rely on credit expansion to make this rise possible.” And again: “The scale of investment grows, and so long as the rate at which it grows remains constant, or even increases, the boom has the power to last. Eventually, however, the moment must come when investment is not suddenly broken off certainly, but ceases to grow at the previous rate. We cannot always be building and ‘rationalising’ further, always constructing new electricity works, etc.—especially as the power of the credit system to go on continually financing this investment delirium is finally exhausted. At this point, the boom must come to an end, since the shrinkage of the capital goods industries is unavoidable.”
• 214These quotations do not make the situation envisaged by our author perfectly clear; but it is the nearest we can get to his meaning. In the second part of this book (see § 5 of Chapter II) it is proposed to work out a situation which perhaps covers what Professor RÖPKE really has in mind.