Prosperity and Depression

CHAPTER 5 UNDER-CONSUMPTION THEORIES

 

§ 1. INTRODUCTION

Historical background.

The under-consumption theories have a long history. In fact, they are almost as old as the science of economics itself. Lord LAUDERDALE, MALTHUS and SISMONDI are prominent among the early adherents of this school of thought. The authors who have done most in recent times to re-state and propagate the under-consumption theory in a scientific way are Mr. J. A. HOBSON1 in England, Messrs. W. T. FOSTER and W. CATCHINGS2 in the United States, and Professor Emil LEDERER3 in Germany.4 The cruder versions of the theory, which exist in innumerable varieties in all countries, will not be considered here, as their fallacy has been clearly demonstrated on various occasions.5

It is difficult to summarise these theories because, with some notable exceptions, their scientific standard is lower than the standard of those reviewed earlier in this volume. They cannot be reviewed as systematically as the over-investment and monetary explanations, for it is only in regard to certain phases of the cycle that these theories have anything original to contribute. The under-consumption theory is a theory of the crisis and depression rather than a theory of the cycle. Those members of the school who attempt to explain the cycle as a whole and deal with all its phases (e.g., Professor E. LEDERER) have taken over many features from—or have much in common with—the monetary and over-investment theories.

The following pages will therefore be not so much a review of a theoretical system totally different from the theories reviewed in the preceding pages as a selection of certain hypotheses which admit of consideration in conjunction with parts of the theories examined earlier. It is possible, as we shall see, to find a logically tenable alternative to the explanation of the crisis given by the over-investment theory; and the new explanation of this particular phase of the cycle seems to be quite compatible with the monetary and over-investment theories’ account of the nature of the upswing and the downswing.

§ 2. DIFFERENT TYPES OF UNDER-CONSUMPTION THEORIES

Various senses of under-consumption.

Another reason why it is difficult to summarise the views of the under-consumption theorists is that under-consumption is not a clear-cut, well-established concept, but covers a great variety of phenomena. It is true that all under-consumption theories are concerned with the alleged insufficiency either of money incomes or of expenditure on consumers’ goods out of those incomes; but the variations between the different theories are very great. We shall now consider briefly the different ways in which under-consumption in one sense or another has been held responsible for the recurrence of economic depressions. Two versions of the theory will finally emerge which seem to merit closer examination.

1. The unqualified statement that, owing to technological improvements and inventions and to the accumulation of capital, there is a tendency for production to outgrow the capacity for consumption—this is the under-consumption theory in its crudest form—can be dismissed offhand as wholly unfounded.

2. Very frequently, “under-consumption” is used to mean the process by which purchasing power is in some way lost to the economic system, and therefore fails to become income and to appear as demand in the market for consumers’ goods. Money disappears or is hoarded, and the income-velocity of money diminishes. In this sense, under-consumption is just another word for deflation. Deflation is, of course, a possible cause of the breakdown of the boom and the main cause of the depression; but, as such, it is covered by the monetary explanation of the business cycle.

Under-consumption and the secular fall of prices.

3. The under-consumption theory is frequently put forward in the following form. There is, it is said, a secular tendency for the volume of production to grow. The population increases. Inventions and improvements raise the output of goods. Additions are made to the stock of capital—that is, to tools and implements. Commodity prices must therefore fall and depression ensue, unless the quantity of money is continuously increased so as to create the consuming power necessary to absorb the increasing output of goods at stable prices. This is certainly too sweeping a statement to be of much value in explaining the course of the cycle. The various factors which make for an increase in the volume of production must be treated separately. In particular, a distinction must be made between growth factors which involve a decrease in the unit cost of production and those which do not. Technological improvements reduce the unit cost of production. Most authorities conclude, therefore, that an increase in production which is due to such improvements does not call for an increase in the quantity of money. In that case, a fall in prices is not harmful, because it goes parallel with a fall in cost and does not involve a fall in money wages and incomes in general. On the contrary, in the face of falling cost, a price-stabilising policy would create a profit inflation and lead to a dangerous boom and later on inevitably to a collapse and depression. To this proposition we shall return later.

In the case of a growing population, the situation is different. Here most authorities (with the notable exception of Professor HAYEK) would agree that the quantity of money ought to increase. Otherwise all prices, including the prices of the factors of production, principally wages, must fall. It goes without saying that this is not a satisfactory arrangement, if only because of the rigidity of wages.6

More difficulties are presented in the case of a growing capital stock. Should the quantity of money be increased in such a way that prices remain stable? And which prices: commodity prices or factor prices?

These problems, which cannot be dealt with exhaustively at this juncture, have been much discussed, principally by monetary writers (in recent times, for example, by Mr. HAWTREY and Professor ROBERTSON).7 They occur in the writings of the under-consumption theorists intermingled with other arguments which will be discussed presently. (It is for this reason that they have been touched upon here, although they do not constitute the heart of the under-consumption theory.)

But what is the bearing of these considerations on the explanation of the business cycle? The growth of population, the enlargement of the capital stock, the improvements in the technical processes of production, are all secular movements. Therefore, the proposition that the supply of money does not keep pace with the growth of production cannot, per se, explain a cyclical movement. It is hopeless to explain the business cycle without taking account of the cumulative nature of the “short-run” processes of expansion and contraction. The considerations in question do not show why these processes are cumulative. Nor do they explain why those processes come to an end sooner or later and give rise at once to a cumulative process in the opposite direction. Their value is rather as a means of determining the trend, a deviation from which, in the one or the other direction, is liable to start a cumulative process of expansion or contraction.

There remains the possibility that the growth of production or the increase in the supply of money moves in cycles. The volume of production shows, of course, a cyclical movement. But this is exactly the phenomenon which is to be explained: it cannot be taken as an independent cause.8 The second assumption that the supply of the circulating medium changes cyclically is the essence of the purely monetary explanation of the business cycle.

We conclude that these arguments put forward under the name “under-consumption” theory are partly irrelevant for the explanation of the short cycle and partly covered by other theories.

Over-saving theory.

4. In its best-reasoned form (e.g., in the writings of Messrs. J. A. HOBSON and FOSTER and CATCHINGS), the under-consumption theory uses “under-consumption” to mean “over-saving”. Depressions are caused by the fact that too large a proportion of current income is being saved and too small a proportion spent on consumers’ goods. It is the process of voluntary saving by individuals and corporations which upsets the equilibrium between production and sales.

The next step in Mr. HOBSON’S analysis is the contention that the cause of over-saving is to be found in the unequal distribution of income. It is principally the recipients of large incomes who are responsible for most of the saving.9 If the wage level could be raised and the national dividend more equally distributed, the proportion of savings would no longer be dangerous. The demand for equalisation of income as a means of reducing cyclical fluctuations, which is very popular in certain quarters, has one of its roots here.

We shall leave this part of the argument on one side, however, and concentrate on the fundamental proposition that over-saving is the cause of the evil.

The activity of saving may conceivably exert an adverse influence on the economic situation in three different ways.

Saving and hoarding.

(a) Saving may lead to depression because savings do not find an outlet in investment. There may be an excess of savings over new investment which will be intensified by every additional act of saving, at any rate where saving extends beyond a certain limit. In other words, saving produces a deflation, a decrease in aggregate demand for goods, because the sums saved are used to liquidate bank credit or are accumulated and hoarded in the shape of cash or idle deposits. There is the further possibility that savings are spent, not in financing new investments, but in buying property and titles to property sold by people who are forced to sell because they have suffered losses. During the depression, when the spirit of enterprise runs low and pessimism prevails, it is probably true to a large extent that saving engenders deflation rather than new investments, and that the slump is to that extent prolonged and intensified. But the breakdown of the boom can hardly be explained in this way. There is no evidence that an absorption of savings occurs during the boom or before the crisis: on the contrary, there invariably exists a brisk demand for new capital, signalised by high interest rates. There is an excess of investment over saving and not the contrary.10 The situation changes, of course, completely after the turning-point, when the depression has set in. Then there is an excess of saving over investement.

But this analysis is no special contribution of the under-consumptionists: it is the common ground of the monetary and over-investment theorists (especially Professor ROBERTSON).

Saving decreases demand for, and increases supply of, consumption goods.

Now we come to the heart of the under-consumption or over-saving theory.

(b) Savings lead on the one hand to a fall in the demand for consumers’ goods, because the money saved is not spent on consumption.

(c) On the other hand, savings are, as a rule, invested productively. The sums saved are used to add to the capital equipment of the community. Factories, railways, power-plants and machines are constructed. The ultimate aim of all this is to increase the production of goods for final consumption.

Thus the demand for consumers’ goods is reduced, their supply is increased and their prices must fall. The market for consumption goods holds the central position in the economic system. So long as all goes well there, the whole productive apparatus, which is piled up behind the consumers’ market and is there only to serve it, will run smoothly: when the equilibrium is disturbed there, the whole economic system will suffer.

Criticism.

To this theory there are serious objections. To say that the situation in the earlier stages of production depends exclusively on the state of affairs in the consumption industry—that, if the latter flourishes, the former will prosper and that, if production falls or stagnates in the latter, the former will necessarily decline or stagnate too—is, in this general and categorical form, certainly wrong. We have already had occasion to discuss a case where a general increase in demand for consumers’ goods and a consequent tendency of the consumption industries to expand production are not only not a sufficient condition of prosperity in the higher stages of production, but, on the contrary, the cause of its collapse. The monetary over-investment theory has shown the possibility that, when at the end of the boom the demand for consumers’ goods rises and their production tends to increase, this upsets the equilibrium between costs and prices in the higher stages, because there are then no idle factors of production which can be drawn into employment in the higher stages, and there are not the necessary funds (capital supply in terms of money) to retain employed factors of production against the competition of the consumption industries.

According to the over-saving (under-consumption) theory, the equilibrium is upset by the opposite course of events—that is, by a decrease in the demand for consumers’ goods. The criticisms to which the theories of Messrs. FOSTER AND CATCHINGS (who have elaborated the over-saving theory most fully) have been subjected by Messrs. DURBIN, HANSEN, HAYEK, ROBERTSON and others,11 have at least shown that, in spite of a high rate of saving, there is always an equilibrium position possible with full employment of the factors of production. This is true in the first instance (that is, during the period of construction of the new capital) as well as in the long run (after the new capital equipment has been put into operation).

The function of saving.

Looking at the problem broadly, it is clear that the social function of saving is to release resources from the production of goods for immediate consumption for the production of producers’ goods.12 Temporarily, the production of consumers’ goods is curtailed in order to permit of increased production at a later point with the help of capital goods which have been constructed in the meantime. The fall in the demand for consumers’ goods has therefore its function. The monetary incentive for the entrepreneur to undertake the construction of new capital equipment, in spite of decreased demand for consumers’ goods, is provided by a fall in the rate of interest, which permits a lowering of unit cost through the utilisation of roundabout methods of production of superior productivity. The cruder versions of the under-consumption theory do not offer an adequate analysis of these essentials of the capitalistic method of production. They therefore do not deal with the possibility of a smooth adjustment of the production process to saving. But it must be admitted that, while their opponents have shown the theoretical possibility of a smooth absorption of savings in new investments, they have not shown its necessity. Entrepreneurs may make no use of the possibility of extending the structure of production. The consumers’ goods industries and the immediately preceding stages will thereupon curtail production; and this may lead to a destruction of purchasing power. This in turn may deter producers in the higher stages from embarking on new investments, in spite of the incentive provided by the fall in the interest rate. All depends on their psychological reactions, on their anticipations. If the money saved is not invested, a cumulative process of deflation will start and saving may thus defeat its own end.

Thus we are back at case (a) discussed above. Much will depend on whether there is a continuous flow or a gradual increase of savings, whether there are violent changes, and whether there is a brisk and continuous demand for new credit (capital) so that an increasing supply is readily absorbed at slightly falling interest rates.13

Let us now apply this analysis to the broad facts of the business cycle. During the depression, demand for new capital is at a low level and inelastic. There is therefore a great danger of new savings running to waste instead of being invested. During the upswing, demand is brisk and new savings easily find an outlet in new investment. Can the over-saving doctrine contribute anything to the explanation of the crisis, the down-turn from prosperity to depression?

There is no evidence for the assumption that the rate of saving rises at the end of the boom and so creates serious difficulties. On the contrary, for reasons which have been touched upon in an earlier passage, it would seem rather that the rate of saving falls in the later phase of the boom.

Valuable aspects of the under-consumption theory.

5. But it has been argued by many writers—and the argument may be said to represent a new version of the under-consumption theory—that the end of the boom comes when the fruits of the new processes which have been initiated with the help of voluntary and forced saving during the upswing begin to emerge. The crisis is brought about, not by a sudden rise in the rate of saving (i.e., a fall in the demand for consumers’ goods) but by a rapid rise in the rate of output (i.e., in the supply of consumers’ goods). This theory, which is the direct opposite of the shortage-of-capital explanation of the breakdown, merits close examination and will be discussed in the next section.

6. Another valuable version of the under-consumption theory is the doctrine that the failure of wages to rise rapidly enough during the upswing—more explicitly, the lag of wages behind prices—is the cause of excessive profits, which in turn entail a dangerous credit inflation and eventually engender serious disturbance of existing relations culminating in a crisis. This theory will be discussed in § 4 of this chapter.

§ 3. INSUFFICIENCY OF CONSUMERS’ DEMAND VERSUS SHORTAGE OF CAPITAL AS THE CAUSE OF THE COLLAPSE OF THE BOOM

Capital shortage versus insufficiency of consumers’ demand.

So far we have encountered, and discussed, the following answers to the question why the cumulative process of expansion always comes to a more or less abrupt end: Disturbances from outside the economic system; insufficiency of the money supply; shortage of capital in the sense of a vertical maladjustment of the structure of production; horizontal maladjustments; a general rise in “cost” and decline of efficiency.

The hypothesis with which we have now to deal is the exact counterpart of the shortage-of-capital theorem. It is important to make the issue and the two answers quite clear. The problem is this: Is the turn from prosperity to depression brought about by a shortage of capital or by an insufficiency of the demand for consumers’ goods? Does the investment boom collapse because the supply of capital becomes too small to complete the new roundabout methods of production, or because consumers’ demand is insufficient to sustain the increased productive capacity?

The argument of the under-consumptionists is this. During the upswing of the cycle, society develops its productive apparatus. But it takes some time before the production of consumers’ goods begins to increase. In the meantime, their supply is deficient; prices rise; and there is therefore a constant stimulus in the direction of further investment. But as soon as the new roundabout methods of production are completed, the new investments are finished, consumers’ goods begin to be poured out; the markets for consumers’ goods are glutted: and this reacts with increasing intensity on the higher stages of production.

According to the other view, exactly the opposite is true. The trouble is due, not to a deficiency of consumers’ demand, but to the contrary tendency. The demand for consumers’ goods tends to rise because the newly created purchasing power, which has been placed at the disposal of entrepreneurs, becomes income in the hands of the owners of the factors of production and is spent on consumers’ goods before the supply of these goods can be sufficiently increased. The demand for consumers’ goods is thus too large rather than too small. There is not enough “waiting”, not enough “lacking” in the terminology of Professor ROBERTSON, or, in ordinary words, not enough saving to complete the investments initiated. The consequence is that the rate of interest tends to rise, and the banks are called upon to provide the necessary amounts of capital. Sooner or later, however, the inflation must be stopped; the flow of new credit comes to an end; and the completion of a great number of new investments becomes impossible. They are consequently abandoned, and this is the break which sets in motion the downward spiral of contraction.

Both theories contemplate what we have called a vertical maladjustment in the structure of production; but these vertical maladjustments are not of the same order. As we shall see at once, the “top” of the structure of production according to the one theory, the “bottom” according to the other, is over-developed in relation to the flow of money. In a sense, both theories can be described as over-investment theories. In the one case, new investments are excessive in relation to the supply of saving; in the other case, they are excessive in relation to the demand for the product. That the distinction is important may be seen from the fact that the conclusions drawn as to the appropriate policy to follow in order to avert, mitigate or postpone the breakdown are diametrically opposed. According to the one view, every measure that tends to increase consumers’ demand and to reduce saving is helpful. According to the other view, exactly the opposite policy is called for. (But such policy, it should be noted, holds only for the later phase of the boom. As soon as the downward movement has got under way and the spiral of deflation has been started, the position changes completely and quite different considerations come into play.)

We must try to make the distinction still clearer and to distinguish these two cases from horizontal maladjustments and from a purely monetary insufficiency. This is not always easy: it is sometimes difficult to ascertain which case a writer has in mind.

The structure of production and the flow of money.

The best method of finding out the exact meaning and implications of the different theories is to ask what are the appropriate measures called for, and to what extent the crisis can be averted by the public changing its habits of saving and spending and the mode of spending (without considering whether in practice this change can or cannot be brought about by State intervention). If an insufficiency of the supply of money, a credit contraction pure and simple, is the sole cause of the termination of prosperity, the situation can be remedied by purely monetary measures—viz., by an increase in the money or credit supply by means of a reduction of interest rates. With a very few exceptions (among whom Mr. HAWTREY is prominent), most writers would agree that in most cases this is impossible.14 The down-turn and the depression can be postponed, but not averted, by a cheap-money policy. The reason is that the difficulties do not arise, or do not solely arise, from an insufficiency of the flow of money in general so much as from the fact that the structure of production— i.e., the allocation of the factors of production to different stages and branches of industry—does not correspond to the flow of money as determined by the distribution of individual money incomes between saving and spending and the different branches of spending. Such a discrepancy cannot be remedied by a simple expansion of credit. The authorities may perhaps determine where the new money is to be spent at first. They can, that is to say, choose the point of injection of the new money into the economic system; but they cannot hope—at any rate without drastic reorganisation of the whole economic system (i.e., without abandoning the existing individualistic organisation of the system)—to control how the money is spent by the successive recipients. But suppose it were feasible to change at will the people’s habit as to saving and spending, what changes would be best calculated to forestall serious trouble? Obviously, if we rule out an insufficiency in total demand, there must be such a distribution of the national income as will make the flow of money correspond to the flow of goods.

The capital-shortage theory replies that all trouble could be avoided if people would consume less and save more, and thus supply the necessary funds for completing the uncompleted roundabout processes of production. The reply of the pure under-consumptionist is the contrary. If people will expand consumption and save less, he says, the breakdown can be averted. That is very well, if the difficulty is due to the too early completion of the new roundabout processes of production. The situation is that people intend to save more, to wait longer. This implies that they are not yet prepared to take over an increased output of consumers’ goods. Over-investment is not a correct description of such a situation. Under-investment would be a better description, since the crisis can be avoided, for the time being at least, by undertaking longer roundabout processes of production—i.e., more ambitious investment schemes which would postpone the appearance of consumable goods on the market.

Saving and investment ex-ante and ex-post.

These two situations can be well described with the help of the terminologica? apparatus developed by some Swedish writers.15 These writers distinguish in respect of saving, investment, income and similar concepts between an ex-ante and an ex-post sense in which these concepts can be used. On the one hand, it is necessary, for the practical business man as well as for the theoretical economist, to find out ex-post what actually happened during a certain period. There must be a system of book-keeping which “answers the question what has happened during a past period. It is an account ex-post” (OHLIN, loc. cit., page 58).

“This, however, explains nothing, for it does not describe the causal or functional relations. As economic events depend on man’s actions, one has to investigate what determines these actions. They always refer to a more or less distant future. Hence, one must study those expectations about the future which govern actions . . . This analysis of the forward-looking type can be called ex-ante, using MYRDAL’S convenient expressions” (OHLIN, loc. cit., page 58–59).

With the help of these concepts, we can now formulate as follows an equilibrium condition which is implicit in the two rival theories under discussion: Ex-ante saving should be equal to ex-ante investment. In other words, the investment plans of entrepreneurs should correspond to the intended savings of the public. If the two do not coincide, some producers will be disappointed and the equilibrium will be disrupted.

The situation envisaged by the capital shortage theorists can now be described as an excess of ex-ante investment over ex-ante saving, which must lead to a disappointment and losses of producers of capital goods (in the higher stages of production), as analysed in detail by Professor HAYEK.

On the other hand, the situation which, according to the under-consumption theorists, typically arises at the end of the boom, can be described as an excess of ex-ante saving over ex-ante investment, which must lead to disappointment and losses on the part of producers of consumers’ goods.16

Both kinds of maladjustment could be avoided by an appropriate change in the saving and spending plans of the public.

If horizontal maladjustments are involved, a shift in the distribution of income between saving and expenditure on consumers’ goods cannot remedy the situation. Changes in consumption habits will then be necessary to restore equilibrium. For example, if the motor-car industry is over-developed, people must be made to buy more motor-cars instead of something else.

It is clear that shortage of capital and insufficiency of consumers’ demand are alternative explanations. The public cannot be reproached at the same time for saving too little and saving too much. But, as Professor ROBERTSON has pointed out,17 it is quite conceivable that, if in a given situation capital shortage was “the actual spear-head of relapse”, insufficiency of consumers’ demand in presence of an increase in output would have brought about the crisis somewhat later.

Difficulty in distinguishing vertical and horizontal maladjustments.

Vertical maladjustments of each type on the one hand and horizontal maladjustments and insufficiency of total demand (insufficiency of money supply) on the other are quite compatible. To a certain extent they probably always go together and are frequently difficult to distinguish. Since many writers do not carefully distinguish these cases, it is often difficult to know which they have in mind. The reason for this ambiguity is perhaps to be found in the fact that, in all these cases, the proximate cause of the breakdown is an insufficiency of demand as compared with the supply coming on the market. This is true, alike in the case of a horizontal maladjustment or an insufficiency of demand for consumers’ goods, and in the case of a capital shortage, which finds its expression in an insufficiency of demand for producers’ goods and “machines” in particular, since possible purchasers cannot get hold of enough “capital” to purchase them (SPIETHOFF). Furthermore, as Professor LEDERER18 has remarked, the fact that the breakdown begins in the producers’ goods industries need not mean that capital shortage is the real cause of the trouble. It is conceivable that the consumption industries may quickly become aware of the limitations of their further expansion in view of the insufficiency of consumers’ demand. If that is the case, they will restrict their orders, and by so doing may precipitate a crisis in the higher stages of production without having themselves got into trouble. This can only be made clear by putting and answering the question with which we started: How should the flow of money between saving and spending and between the various branches of spending be modified in order to restore equilibrium?

Lederer’s theory.

Professor LEDERER explains the breakdown of the boom chiefly by insufficiency of consumers’ demand. (How he explains the genesis of this insufficiency will be seen in the next section.) He says that equilibrium could be easily restored if wages were increased and profits lowered19—that is to say, the rate of saving (he says, of “accumulation”) must be reduced and the rate of consumption increased. This is brought about eventually during the crisis and depression.20 But he makes an important qualification. He says that, so far as “the crisis originates from a disproportion in the sphere of production” (in contradistinction to a disproportion in incomes), it cannot be cured by a rise in wages. He seems to be thinking of what we call horizontal maladjustments in the structure of production, and (later on) of the deflation during the depression. If the value of money which was lowered during the boom is gradually restored during the depression, wages must fall. But he insists that wages should fall less than prices. If they fall more rapidly than prices, the crisis is intensified.

A monetary under-consumption theory.

Professor Hans NEISSER has worked out a theory which could be described as a “monetary under-consumption theory”.21 He explains the breakdown of the boom by under-consumption in the sense defined above and analyses carefully how the difficulties in the consumers’ goods industries are likely to entail deflation and so spread the trouble to all parts of the system. He is not exclusively an under-consumption theorist; he points out that other reasons for the collapse of the boom, such as under-saving (the opposite of under-consumption), are not at all inconceivable and have actually brought a number of cycles to an end. He believes, however, that the situation is especially serious if the trouble first arises in the consumption industries, for this constitutes, so to speak, an “endogenous” cause of deflation. When consumption industries suffer losses, investment will at once be curtailed and recession will spread immediately to the upper stages of production while, according to him, a difficulty which arises in the capital goods industries is in itself no sufficient reason for a decline of production in consumers’ goods industries.

Importance of construction period in the upswing.

An influential sponsor of the view that the breakdown of the boom is brought about, not by a shortage of capital, but by insufficiency of demand in face of a rapid increase in the output of consumers’ goods is Professor Albert AFTALION.22

Professor AFTALION builds his theory largely on the acceleration principle. Moderate increases or reductions in the production of consumers’ goods give rise to relatively large fluctuations in the production of capital equipment. The boom is stimulated by a deficiency of consumers’ goods; and this leads to an increase in the production of capital goods. But the modern capitalistic process of production is time-consuming. The construction of capital goods which must precede the production of consumers’ goods takes months or even years. Therefore, the output of consumers’ goods does not rise at once, or at any rate does not at once rise sufficiently. Prices of consumers’ goods remain high, the profit margin persists, and there is a constant stimulus to produce capital equipment. This phase of capitalistic production, in which capital goods are being created, is the period of prosperity. It is the capitalistic technique of production, the fact that a long time must elapse before the output of consumers’ goods can be increased, which prolongs the prosperity period, over-stimulates the construction of capital goods, and leads finally to a disruption of economic equilibrium.

The breakdown comes when the roundabout processes of production which have been started during the upswing are completed and consumers’ goods begin to pour out. It is of course true that the duration of the processes of production is not uniform for all types of goods. Therefore, the processes of production which have been initiated will not all be completed at the same time. The prosperity does not terminate when a single process is finished; it ends only when a great quantity of capital in the majority of industries is set to work turning out consumers’ goods.

Professor AFTALION compares the time required for the manufacture of means of production to the time which elapses between the moment of rekindling a fire and the moment at which it begins to give off heat. “If one rekindles the fire in the hearth in order to warm up a room, one has to wait a while before one has the desired temperature. As the cold continues, and the thermometer continues to record it, one might be led, if one had not the lessons of experience, to throw more coal on the fire. One would continue to throw coal, even though the quantity already in the grate is such as will give off an intolerable heat, when once it is all alight. To allow oneself to be guided by the present sense of cold and the indications of the thermometer to that effect is fatally to overheat the room.”23

The idea that the length of the prosperity phase of the cycle depends on the duration of the new productive processes (which is, in the main, the period of construction of new capital equipment) has been widely re-echoed. Professors PIGOU and ROBERTSON attribute to what they call the gestation period of capital goods,24 which is substantially equivalent to the period of construction, an important rôle in determining the length of the upswing. It is also part of Professor SCHUMPETER’S theory that the boom is terminated when the new productive processes are completed and an additional flow of finished goods appears in the market.

The view of these writers is that the upswing is usually concentrated in one or two leading industries—railway construction in the third quarter of the nineteenth century and, later, electrical machinery and automobiles.

It must be admitted that the exact classification of these theories is not easy. It is not always apparent whether all these writers are thinking of over-saving in the strict sense in which we have defined it above, when they say that the consumers’ demand is insufficient to absorb the swollen stream of goods flowing into the market. It is not always quite clear whether they are not thinking also of horizontal maladjustments or some other maladjustments which may have no place in this conspectus of the position. The “gestation period” of durable goods may also be interpreted as meaning that the capital supply (i.e., the flow of saving) is insufficient to absorb the new capital goods as they are completed. The obscurity will remain in the absence of answers to the initial question as to what changes in the flow of money from saving to spending, from spending to saving, or from one branch of spending to another, are capable of restoring equilibrium or forestalling disturbance.25

Unfortunately, explicit answers to this question are few and far between. But, since we are interested rather in possible theories (that is, in hypothetical explanations) than in theorists and their doctrines, we may leave the matter there.

§ 4. THE FAILURE OF WAGES TO RISE SUFFICIENTLY AS THE CAUSE OF THE EXCESSES OF THE BOOM

Lag in wage-rise stimulates investment.

In its bare outline, the argument is this. The prosperity phase of the cycle is characterised by a great increase in the production of capital goods. The breakdown is caused by “over-investment”. (As will be seen later, it is not always clear exactly what the authors whose theories are discussed in this section mean by over-investment.) The necessary stimulus and the necessary funds for these investments are derived, in part at any rate, from the excessive profits of entrepreneurs. This profit-inflation can and must arise because wages and certain other incomes fail to advance in harmony with rising prices or falling costs due to rapid technical progress.

This theory has been used to explain the business cycle in general by E. LEDERER26 and E. PREISER.27 In recent Writings, it has frequently been advanced as an explanation ad hw of the last American boom.28

It is obviously closely connected with the monetary over-investment theory. A certain lag of wages or other income (especially, of the relatively inflexible incomes such as those of State officials, pensioners, rentiers, the holders of fixed-income-bearing securities, and the like) is a normal and important corollary of forced saving—that is, of the formation of capital by means of an inflationary expansion of credit. If wages and all other incomes were to rise automatically with, and to the same extent as, prices with each injection of new money, there would be little scope for forced saving.

As we have seen, the monetary over-investment theory runs mainly in terms of the rate of interest. According to it, the expansion is brought about by the fact that the rate of interest is too low, either because the money rate of interest has been lowered or because the natural rate has risen. It is obviously compatible with this view that the movement of wages and other incomes should also have a determining influence. If wages, etc., fail to rise, profits swell; and this provides a strong stimulus for further expansion of credit and investment. In the terminology of the over-investment school, the profit rate rises; hence the demand for credit goes up and credit inflation ensues. Thus the lag of wages and other income is an important factor in the reinforcement of the cumulative expansion process. It follows that the boom could be stopped by a sufficient rise of wage rates as well as of interest rates.

So far, this type of under-consumption theory29 and the monetary over-investment theory are in no way contradictory, but are rather complementary to each other. There seems also to be agreement that credit expansion is a necessary feature of the picture.

Wage-lag as viewed by over-investment theorists and by under-consumptionists.

The difference between the two groups arises over the question, why exactly does the boom eventually collapse? What is the nature of the disequilibrium, and which factor does the mischief?

According to the over-investment theory, the credit expansion is the villain of the piece. Excessive profits due to the lag in wages and other inflexible incomes are harmful only in so far as they are responsible for inflationary credits, which in turn lead to over-investment in the sense defined above.

Excessive profits as source of saving.

To the under-consumptionist group, the danger in the excessive profits is not that they induce a credit inflation, but that they are the source of excessive saving. It is a widely held belief, accepted by socialists and liberals, under-consumptionists and over-investment theorists30 alike, that the bulk of a nation’s savings comes from the higher income strata. The profit-recipients and not the wage-earners provide the funds for investment. Therefore, when profits rise relatively to wages and other incomes, the flow of savings grows. Thus far the monetary over-investment theorist is in agreement. In fact, he welcomes the idea as a useful addition to his picture of the boom. The expansion of capital-goods industries relatively to consumption trades is financed, not only by inflationary credits (flowing from various sources) and ordinary voluntary savings, but also by new additions to voluntary savings out of the big profits realised during the boom,31 These profits are supposed to be very substantial, and the sums set aside for investment purposes are excessive. Too much is invested; and this leads eventually to the collapse of the boom. The breakdown could be avoided, if the profit-recipients would choose to expand their consumption instead of investing.

The process as pictured by the under-consumptionists can also be described as over-investment. But a closer analysis shows that, by over-investment, they mean the contrary of what the monetary over-investment theorists mean by over-investment. For the writers with whom this section is concerned, investments are excessive in respect to consumers’ demand and not in respect to capital supply. Over-investment is equivalent to insufficiency of consumers’ demand and not to insufficiency of the flow of savings. “The failure of the income of the final consumer in the end checked the process” of expansion in America in 1929.32 “Relatively to the means of the ultimate consumer, the vast expansion of capacity in durable-goods industries and the huge volume of domestic and factory buildings erected were altogether excessive.”33 “This lopsided growth in the division or distribution of the national money income brought about a rapid development of industry, ending in our present condition, which is marked by excessive productive power and a deficiency of consumers’ money income.”34 This seems to be also the idea of Mr. PREISER.35

Thus, this version of the under-consumption theory turns out to be the same as that discussed in the previous section. But the conclusion was not inevitable from the first. If we start with the proposition that a lag of wages and other income during the upswing intensifies the boom, it is quite possible to pursue the argument along the lines of the monetary over-investment theory and to hold that the collapse is brought about by an insufficiency of capital supply (i.e., of the flow of savings).

It would seem logical to conclude that an increase in the flow of investible funds which is due to a rise in profits (that is, to a rise and redistribution of income) has exactly the same influence and consequences as an increase due to a rise in the rate of voluntary savings (without any change in the size and distribution of income). Hence, those writers who lay the blame on high profits should also take objection to any rise in the rate of savings.

“Autonomous” and “heteronomous” saving.

This conclusion is, however, expressly rejected by Mr. PREISER. He has the idea that a rise of investible funds due to higher profits (he calls this “heteronomous” saving) is a quite different phenomenon from an increase due to a rise in the rate of saving from an unchanged income (“autonomous” saving). While the first must lead to a collapse, he sees no reason why the second should not go on indefinitely. The difference is not only of degree, but also of kind. It arises from the alleged fact that the appearance of profits makes the misdirection of capital inevitable. In the case of autonomous saving, it is the rate of interest which guides the entrepreneur in his investment policy. The savings are directed over the capital market, which guarantees a rational distribution. When profits appear everywhere, the investor has to grope in the dark. He has lost connection, so to speak, with the demand of the ultimate consumer; for “heteronomous” savings do not flow through the capital market (pages 80 and 84). The passages quoted in an earlier footnote show that the author does not make it clear what he means by misdirection of capital; is there too much all round in relation to aggregate consumers’ demand, or too much in particular branches at the expense of others?

 

 

________________

36 See The Industrial System, London, 1909, 1910; Economics of Unemployment, 1922; Rationalisation and Unemployment, London, 1930.

37 See Money, Boston, 1923; Profits, Boston, 1925; The Road to Plenty, Boston, 1928.

38 “Konjunktur und Krisen” in Grundriss der Sozialokonomie, Tübingen, 1925; Technischer Fortschritt und Arbeitslosigkeit, Tübingen, 1931.

39 While not himself primarily an advocate of the underconsumption thesis, Mr. Keynes has laid great stress on the deflationary character of acts of saving. In the General Theory of Employment, Interest and Money, London, 1936, he has forged, in the concept of the “propensity to consume” an instrument apt for the purposes of the underconsumption theory. The implications of this concept have been more fully developed by Mr. Harrod in his work, The Trade Cycle, Oxford, 1936.

40 For example, by E. F. M. Durbin’s Purchasing Power and Trade Depression, London, 1931, and H. Gaitskell’s contribution to What Everybody wants to know about Money, ed. by G. D. H. Cole, London, 1933. pages 348 et seq.

41 This Professor Hayek too would admit. But he thinks that the injection of money necessary to prevent the fall in wages would create a vertical maladjustment in the structure of production, of the kind that we have discussed in the section on the monetary over-investment theory. See Prices and Production, 2nd ed., 1934, Page 161.

42 Compare also G. Haberler, The Different Meanings attached to the Term “Fluctuations in the Purchasing Power of Gold” and the Best Instrument or Instruments for measuring such Fluctuations (Memorandum submitted to the Gold Delegation of the League of Nations, 1931) A German translation appeared under the title: “Die Kaufkraft des Geldes und die Stabilität der Wirtschaft,” in Schmoller’s Jahrbuch, Vol. 55, 1932. See also W. Egle, Das neutrale Geld, Jena, 1933, and J. G. Koopmans, “Zum Problem des neutralen Geldes,” in Beitrage zur Geldtheorie, Vienna, 1933. The older literature is well reviewed in C. M. Wash, The Fundamental Problem in Monetary Science, New York, 1903.

43 By an “independent cause” is meant a change produced by outside factors which can be taken for granted by the economist, such as changes in agricultural production, due to weather conditions. Nothing of this sort is to be found in industrial production.

44 Statistical evidence is to be found, e.g., in America’s Capacity to Consume, edited by the Brookings Institution, Washington, 1934.

45 It should be noted that the terms “savings” and “investment” are used here in the ordinary meaning of the two words. Mr. Keynes, in his Treatise on Money, has given them a very peculiar definition, according to which an excess of savings over investment does not imply deflation but is, by definition, equal to losses, and an excess of investment over savings equal to profits. An extensive discussion of the problem of defining saving, investment and hoarding is to be found in Chapter 8, below.

46 See Durbin: Purchasing Power and Trade Depression, London, 1933; Hansen: Business Cycle Theory, 1928, Chapter III; Hayek:”The Paradox of Saving” in Economica, May 1931; D. H. Robertson: “The Monetary Doctrines of Messrs. Foster and Catchings” in Economic Essays and Addresses of Pigou and Robertson, London, 1931.

47 Compare especially C. Bresciani-Turroni, “The Theory of Saving,” in Economica 1936.

48 Bresciani-Turroni, loc. cit.

49 See A. Amonn: “Zur gegenwärtigen Krisenlage und inflationistischen Krisenpolitik” in Zeitschrift für Nationalökonomie, Vol. V, 1934, Page 1 and passim.

50 Compare especially G. Myrdal, “Der Gleichgewichtsbegriff als Instrument der geldtheoretischen Analyse” in Beiträge zur Geldtheorie, edited by Hayek, 1933, and B. Ohlin, “Some Notes on the Stockholm Theory of Savings and Investment” in Economic Journal, Vol. 47, 1937, pages 53 et seq, and pages 221 et seq. For further details of this approach, see Chapter 8.

51 Certain differences, fundamentally of a terminological kind, between the Swedish analysis and the analysis used by the writers dealt with in the text will be discussed more thoroughly in Chapter 8 below.

52 In “Industrial Fluctuations and the Natural Rate of Interest,” Economic Journal, December 1934.

53 “Konjunktur und Krisen” in Grundriss der Sozialökonomie, IV Abteilung, 1. Teil, Tübingen, 1925, page 394.

54 Op. cit., page 401.

55 Op. cit., page 394. He seems to overlook the alternative possibility of the breakdown being caused by capital shortage—that is, by undersaving and over-consumption. Speaking about Spiethoff’s theory, he says: “An over-production in the earlier stages of production, in the coal-mines, iron-and-steel works, etc., obviously means only that the demand for finished goods cannot rise to that extent which would correspond to the actual production of producers’ goods” (page 386).

56 “General Over-production. A Study of Say’s Law of Markets” in Journal of Political Economy, Vol. 42, 1934, pages 433-465. Cf. also his book: Some International Aspects of the Business Cycle, Philadelphia, 1936.

57 Les crises périodiques de surproduction, Paris, 1913. See also his article “The Theory of Economic Cycles based on the Capitalistic Technique of Production” in the Review of Economic Statistics, October 1927, pages 165 et seq. Only part of Aftalion’s theory will be examined here. On the whole, his theory cannot be classified as an under-consumption theory: but his explanation of the crisis as reviewed in the text is the same as that of the under-consnmptionists. His explanation of the cycle as a whole suffers from the inadequacy of the analysis of the monetary factor. Compare the criticism by D. H. Robertson in Economic Journal, Vol. 24, 1914, page 81, and A. H. Hansen’s review in Business Cycle Theory, pages 104-111.

58 Substantially the same theory is advanced by F. W, Taussig, Principles of Economics, 3rd ed., Vol. I, pages 391 and 392. This idea has been frequently used for the explanation of cycles in particular industries—i.e. the “hog cycle”, “shipbuilding cycle”, etc.

59 This is also stressed by F. Lavington: The Trade Cycle, an Account of the Causes producing Rhythmical Changes in the Activity of Business, London, 1922, page 72.

60 Cases are of course conceivable in which no such change would be sufficient to restore equilibrium.

61 Lederer, op. cit., pages 393 and 394.

62 Preiser: Grundzüge der Konjunkturtheorie, 1933.

63 Cf. A. D. Gayer: Monetary Policy and Economic Stabilisation, pages 113-131, 1935, and A. B. Adams: Our Economic Revolution, pages 1-15, 1934.

64 It may, of course, be argued that this type of theory is not properly an “under-consumption” theory, since it stresses the cost aspect of wages, etc., rather than the fact that they constitute demand for consumers’ goods. There is also a certain contradiction, at least on the surface, in that the same writers who see in a lag of wages a stimulating factor for the boom are nearly all of the opinion that a fall in wages intensifies depression. That is to say, they advocate a rise in wages in order to check the boom and to combat the depression. It would, however, seem possible to reconcile these two propositions by special assumptions about the monetary situation. During the depression, a fall in wages may conceivably lead to the liquidation of bank credit, while a failure of nominal wages to rise during the upswing does not have the same deflationary or anti-inflationary effect.

65 The one group draws the conclusion that an unequal distribution of income is a good thing, the other that it is a bad thing.

66 This is also Mr. Hawtrey’s view. He does not believe that these voluntary savings are supplemented to any considerable extent by inflationary bank credit placed at the disposal of producers. According to him, additional bank credit enters the economic system rather by way of the dealer—that is, near the consumers’ end of the structure of production—than by direct stimulation of investment in fixed capital and in the higher stages of production as the monetary over-investment theory would have it.

67 Gayer, op. cit., page 127.

68 Ibid., page 128.

69 Adams, op. cit., page 9.

70 Op. cit.: “The continuation of the production process finds its barrier, in every case, in the ultimate consumption” (page 106Ì. “The recession comes, because the accumulation was excessive” (page 110). It is true, however, that there are other passages where he seems to be thinking of “horizontal disproportionalities”—e.g., on pages 84 and 85.

• 1The 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.
• 2With 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).
• 3In 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.
• 4In 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.
• 5He 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”.
• 6It 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.
• 7One 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.
• 8One 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.
• 9The 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).
• 10“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.”
• 11“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.”
• 12In 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.
• 13The 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.”
• 14In 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.
• 15But 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”.
• 16To 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.
• 17Under 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”.
• 18If 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.
• 19With 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.
• 20A 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.
• 21This 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.
• 22It 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.
• 23Treatment 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.
• 24It 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.
• 25Apart, 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.”
• 26In 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.
• 27In 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.
• 28But, 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.
• 29Professor 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.
• 30But 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.
• 31Against 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.
• 32Furthermore, 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.
• 33To 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.
• 34Against 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.
• 35The 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.
• 36Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.
• 37See his book: Strategic Factors in the Business Cycle, passim.
• 38The Lessons of Monetary Experience, page 131.
• 39Ibid., page 131, and Monetary Reconstruction, page 133.
• 40Capital and Employment, page 86.
• 41See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.
• 42For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 43What 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.
• 44This 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.
• 45Op. cit., page 171.
• 46Trade and Credit, London, 1928, page 98.
• 47Cf. 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.
• 48Currency and Credit, 3rd ed., London, 1928, page 153.
• 491913, page 186.
• 50Monetary Reconstruction, 2nd ed., London, 1926, page 135.
• 51See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
• 52Currency and Credit, 3rd ed., page 155.
• 53It 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).
• 54See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
• 55No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
• 56The 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).
• 57A. H. Hansen and H. Tout, in “Investment and Saving in Business Cycle Theory,” Econometrica, April 1933, have pointed out the underlying assumptions.
• 58Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.
• 59The 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).
• 60Banking Policy and the Price Level, 1932 ed., page 48.
• 61Ibid., page 57.
• 62Ibid., page 58.
• 63“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.
• 64See 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.
• 65Since 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.
• 66Hayek, op. cit., pages 160 and 161.
• 67Such 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.
• 68The 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.
• 69Mr. 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.
• 70Cf., 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.