Prosperity and Depression

§ 1. INTRODUCTION

Psychological and economic factors.

It is in a way misleading to speak of “psychological” explanations of the trade cycle or of particular phases of it. Every economic fact has a psychological aspect. The subject-matter of economic science is human behaviour—chiefly conscious and deliberate behaviour—which can hardly be separated from its psychological basis. The psychology of human behaviour is therefore a constituent part of the subject-matter of economics. When we assume that an entrepreneur will increase his output if demand rises or cost is reduced, or that workmen will respond to changes in money wages but not so readily to changes in real wages, or that consumers will buy more of a given commodity if the price falls and less if they think it will fall further, or that people will hoard money if the value of money rises—ail these assumptions are assumptions about human behaviour which presuppose a certain state of mind on the part of the human agents. Propositions about such actions may be considered as belonging to the sphere of applied psychology: but they also figure continually, whether implicit or expressed, in the economic theories of the cycle. What, then, distinguishes a “psychological “theory from an “economic” one?

There is really no fundamental difference between the “economic” theories already reviewed in these pages and the so-called “psychological” theories. Both make assumptions as to economic behaviour in certain situations. The real difference is sometimes this; The “psychological” theories introduce certain assumptions about typical reactions, mainly on the part of the entrepreneur and the saver, in certain situations; and these reactions are conventionally called psychological, because of their (in a sense) indeterminate character. But the distinction between the writers who give prominence to these “psychological” factors and the writers so far reviewed is, taken as a whole, a distinction of emphasis rather than of kind. The “psychological “factors are put forward as supplemental to the monetary and other economic factors and not as alternative elements of causation, while on the other hand, though they may be assigned a less prominent place in the chain of causation, they are in no sense overlooked by the majority of writers of the other group.

§ 2. ANALYSIS OF THE PSYCHOLOGICAL FACTOR IN THE EXPLANATION OF THE BUSINESS CYCLE

Stress on expectations.

The writers who have laid the greatest stress on “psychological “reactions in the explanation of the various phases of the cycle are KEYNES,1 LAVINGTON,2 PIGOU3 and TAUSSIG.4

Of the writers whose theories have been analysed earlier in this report, MITCHELL, ROBERTSON, RÖPKE, SPIETHOFF all attach a certain importance in their system to “psychological” elements.

It remains to define more precisely the actions and reactions in connection with which the operation of “psychological” factors is postulated by these writers in their explanation of the cycle. “Psychological “factors come into consideration in economic theory in connection with anticipations and expectations. Static theory and those business-cycle theories which are in the main based on the static hypothesis—of which the most typical exponent is perhaps Professor HAYEK—picture the entrepreneur’s decisions as to the volume, and alterations in the volume, of output and employment as being determined by a comparison of prices and costs—that is to say, the price of his product or products and the price of the means of production. “Price” and “cost “are economic terms: but what the economist is concerned with— in all but a few unimportant limiting cases—is expected future prices and cost. The prices, costs, profit margins, etc., by which the producer is guided in his decision, should be conceived of, in short, not simply as given factors, but as factors expected to rule in the future.5 This is so even in the simplest case—the case which seems to underlie a large part of static theory—where the producer is guided in his decisions solely by current prices. Prima facie, it might seem that in this case no element of expectation is present. But this is not so: the expectation in this case is the hope or belief that current prices6 will continue to dominate the future.

Expectations are uncertain.

With the introduction of the element of expectation, uncertainty enters the field. Future events cannot be forecast with absolute precision; and the farther they are distant in the future, the greater the uncertainty, and the greater the possibility of unforeseen and unforeseeable disturbances. Every economic decision is part of an economic plan which extends into the more or less distant future. In principle, there is therefore always an element of uncertainty in every activity. There are, however, certain cases where the element of uncertainty is especially great and conspicuous, such as the case of investment of resources in long processes and durable plant and the provision of funds for these purposes. The longer the processes in which capital is to be sunk, and the more durable the instruments and equipment to be constructed, the greater the element of uncertainty and risk of loss.

Naturally, economic actions and reactions in such cases are less rigidly determined by observable facts than in other cases. It is therefore mainly here that the “psychological” theories make their essential contribution. Optimism and pessimism are introduced as additional determinants. An attitude of optimism is an attribute of the prosperity phase of the cycle, and an attitude of pessimism an attribute of the depression; and the turning-points are marked by a change from optimism to pessimism and vice versa.

Optimism and pessimism.

What do these new elements add to the picture of the expansion and contraction process which has emerged from the analysis of the “non-psychological” theories reviewed so far? If the psychological argument that during the upswing people take a more optimistic, and during the downswing a more pessimistic, view meant no more than that people invest more freely during the upswing and are reluctant to invest during the downswing, it would add nothing at all to the picture of the upswing and downswing as drawn by the monetary over-investment theory. But the psychological theories mean, of course, more than that. Optimism and pessimism are regarded as causal factors which tend to induce or intensify the rise and fall of investment which are characteristic of the upswing and downswing respectively. But are optimism and pessimism really separate factors definitely distinguishable from those analysed in the non-psychological theories of the cycle? The factors and forces making for cumulative expansion may be defined, broadly speaking—as they are denned in these theories—as low interest rates and/or the appearance of new investment opportunities as a result of inventions, changes in demand, etc., which are themselves the consequences of growth of population, the need for replacement of outworn equipment and so on. An increase in investment, however brought about, leads to an inflow of new money into the circulation and so to a rise in the money demand for goods in general which in turn stimulates investment: the process is cumulative. An indispensable condition is of course an elastic money supply. What now is changed, if to this list of factors optimism and pessimism are added as intensifying elements? If all that is meant is that a fall in the rate of interest, or the appearance of an invention requiring for its application a heavy investment of capital, or a rise in demand makes people anticipate better returns from particular investments, there is no new element in the mechanism as pictured by, say, the monetary over-investment theory, since to the latter too profits can only mean expected profits.

Entrepreneurs’ reactions are indeterminate.

But the introduction of optimism and pessimism as additional factors signifies more than this. It implies that the connection between a fall in the interest rate and a change in the other objective factors, on the one hand, and the decision of the entrepreneur to invest more, on the other hand, is not so rigid as the “economic” theories sometimes maintain. If in a given situation the rate of interest falls, or demand increases, or there is a change in the technological situation (exploitation of an invention or introduction of an innovation), it is not possible on the basis of these data alone to predict the strength of the entrepreneurs’ reactions or the extent to which they will increase investment. It is true, such phrases as “the degree of optimism” or “a change in optimism” are omnibus formulae which conveniently cover a number of other factors such as the general political situation and other elements likely to influence the outcome, though to an unknown extent. It should be clearly recognised that, while it is true that developments are not determined wholly by the objective factors with which the non-psychological theories are concerned, the introduction of the determinants “optimism” and “pessimism” makes no positive contribution to the explanation of the cycle so long as the optimism and pessimism remain purely psychological phenomena—i.e., states of mind of the entrepreneurs (or other members of the economic community with whose behaviour the theory is concerned). We cannot observe states of mind; but it is possible to make certain observations from which states of mind or changes of mind can be inferred. It is at this point that the “psychological” theories have a positive contribution to make.

“Irrational”influences stressed by “psychological” theorists.

What observable factors are there (other than those which have already been taken into account by the “non-psychological” theories) that go to make people optimistic or pessimistic—i.e., that stimulate or discourage investment? There is in the first place the fact that, in a period when demand and production are rising in many branches of industry, producers in branches which have not yet felt an increase in demand are inclined to expect one. The connection between the objective factors (interest rate, etc.) with which the non-psychological theories are concerned and the volume of investment is, as it were, loosened. The response of total investment to changes in the objective factors becomes stronger than “rational” economic considerations would suggest. Professor PIGOU, in this connection, speaks of “errors of optimism”. LAVTNGTON likens business-men who infect each other with confidence and optimism to skaters on a pond. “Indeed, the confidence of each skater in his own safety is likely to be reinforced rather than diminished by the presence of numbers of his fellows. . . . The rational judgment that the greater their numbers the greater will be the risk is likely to be submerged by the mere contagion of confidence which persuades him that the greater the numbers the more safely he himself may venture.”7

Another point to which the psychological theories direct attention is the fact that, when demand and prices have continued for a while to rise, people get into a habit of expecting more and more confidently a further rise of equal or approximately equal extent—that is to say, they project current experience too confidently into the future. All this leads them to an excessive valuation of capital assets. As Mr. KEYNES says: “It is an essential characteristic of the boom that investments which will in fact yield, say, 2% in conditions of full employment are made in the expectation of a yield of, say, 6%, and are valued accordingly.”8

Errors of optimism create errors of pessimism.

The theorists who stress the psychological factor, especially Professor PIGOU and Mr. KEYNES, point out, furthermore, that the discovery of errors of optimism gives birth to the opposite error of pessimism. Professor PIGOU speaks of “the mutual generation of errors of optimism and pessimism”.9 The above passage from Mr. KEYNES continues: “When disillusion comes, this (optimistic) expectation is replaced by a contrary ‘error of pessimism with the result that the investments which would in fact yield 2 % in conditions of full employment are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investment, which would have yielded 2% in conditions of full employment, in fact yields less than nothing.”10

Professor PIGOU points out that “the extent of the revulsion towards pessimistic error, which follows when optimistic error is disclosed, depends, in part, upon the magnitude of the preceding optimistic error. . . But it is also affected by what one may call the detonation which accompanies the discovery of a given amount of optimistic error. The detonation is greater or less according to the number and scale of the legal bankruptcies into which the detected error explodes.” 11 If the enterprises which are making losses have been financed by the entrepreneurs with their own money, the repercussions are less serious than in the case where they have been financed by borrowing, especially by borrowing from the banks.

§ 3. SUMMARY

Compatibility with other theories.

We can now sum up our analysis of the contribution of the psychological explanation of the cycle and its relation to the non-psychological explanations.

The “psychological” theorists are writers who lay more stress on—or attribute more independent influence to—the “psychological”, as opposed to the “non-psychological”, factors than other theorists. The argument that optimism or pessimism is a contributory factor in the process of expansion or contraction simmers down to the proposition that, for a number of reasons, the reaction of investment to a change in the determinant objective economic factors (interest rate, flow of money, etc.) is likely to be stronger than the analysis of the purely “economic” theories would at first sight suggest.

Mr. HAWTREY, in his review of PIGOU’S Industrial Fluctuations12 endeavours to make the point that optimism and pessimism are wholly dependent on the policy of the banks. People are optimistic, he says, so long as credit expands and consequently demand rises: they become pessimistic when credit is contracted and demand flags. On the whole, this is probably correct. But the fact remains that the reaction of activity (i.e., mainly, of investment activity) to given changes in interest rates and in the demand for consumers’ goods, etc., may be different under different circumstances. The “psychological” explanations seek to analyse certain of the more elusive circumstances on which the strength of the reaction depends. In terms of the demand-and-supply schematism of investible funds, we may say that the reference to the psychological factor or factors is to be represented by an accentuation of the shift of the demand curve to the left during the depression and to the right during the upswing of the cycle.

There is one other important point. The psychological theories as such are not concerned with specific assumptions as to the nature of the maladjustment which brings about the collapse of the boom. The result of the optimistic error with which the psychological theories are concerned may be shortage of capital, insufficiency of consumers’ demand or horizontal misdirection of capital: the “psychological” theory is compatible with any or all of these hypotheses.13

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14 General Theory of Employment, Interest and Money, London, 1936, Chapter 22 (“Notes on the Trade Cycle”).

15 The Trade Cycle, an Account of the Causes producing Rhythmical Changes in the Activity of Business, London, 1922.

16 Industrial Fluctuations, 2nd ed., London, 1929.

17 Principles of Economics, 3rd ed., Vol. I, page 393.

18 In recent years, it has become fashionable to lay stress on the element of expectation. Keynes’ General Theory of Employment, Interest and Money is conceived in terms of expectation; and, at an earlier date, the concept of economic expectation was interpreted and developed by the Swedish school (especially E. Lindahl, G. Myrdal and B. Ohlin: see Myrdal’s report on this Swedish literature in his article “Der Gleichgewichtsbegrifl als Instrument der geldtheoretischen Analyse” in Beiträge zur Geldtheorie, edited by Hayek, Vienna, 1933: see also a number of articles by J. R. Hicks, viz., “Gleichgewicht und Konjunktur” in Zeitschrift für Nationalökonomie, Vol. IV, No. 4, 1933, pages 441 et seq.; “A Suggestion for simplifying the Theory of Money” in Economica, February 1935. page 1; and “Mr.Keynes’ ‘General Theory of Employment, Interest and Money’” in Economic Journal, Vol. XLVI, June 1936). It should not, however, be forgotten that even the theories of authors who do not usually refer explicitly to expectations and anticipations can, and should, be interpreted in terms of expectation, as the authors in question are themselves often well aware (cf., for example, Hayek’s article “Preiserwartungen, monetäre Störungen und Fehlinvestitionen” in Nationaleko-nomisk Tidsskrift, Vol. 73, pages 176-191—French translation “Prevision de prix, perturbations monétaires et faux investissements” in Revue des Sciences économiques, 1935). Professor Morgenstern has a trenchant analysis of the problem of expectations and anticipations in his Wirtschaftsprognose, eine Untersuchung ihrer Voraussetzungen und Möglichkeiten, Vienna, 1928, and his article “Vollkommene Voraussicht und wirtschaftliches Gleichgewicht” in Zeitschrift für Nationalökonomie, Vol. VI, Vienna, 1935, pages 337-358.

19 The reference in this case is to prices: but what is true of prices is equally true of other factors in economic decisions. In perfectly competitive circumstances, price is the only factor which the producer has to forecast. In monopolistic circumstances, it is rather the “demand” than the “price” with which he is concerned, since the price is not in such case independent of the action of the producer.

20 Op. cit., page 32 and 33.

21 Op. cit., page 321.

22 Industrial Fluctuations, Chapter VII.

23 Op cit., page 322.

24 Op. cit., page 94.

25 Trade and Credit, page 168.

26 In the passage quoted, Mr. Keynes seems to suggest that no actual losses are needed to make a boom collapse—i.e., that no maladjustment in the structure of production need occur (where by maladjustment is meant an arrangement of the productive structure which implies losses at least for some firms). A fall in profits, he seems to argue, may be sufficient to make the boom collapse, if, for example, it creates expectations of a further fall in profits to zero or less than zero. This interpretation of Mr. Keynes’ theory presents, however, great difficulties, inasmuch as, in his Treatise on Money, he defines an entrepreneur making losses as one whose remuneration has fallen to such a level as to induce him to restrict output. The difficulty is perhaps purely verbal, due to a change in his definition of loss and profit. In any case, the idea is not sufficiently developed to admit of fruitful discussion.

• 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.
• 5It 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.
• 6One 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.
• 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.
• 8The 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).
• 9“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.”
• 10A 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.
• 11But, 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.
• 12“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.”
• 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.”
• 14Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.
• 15See his book: Strategic Factors in the Business Cycle, passim.
• 16The Lessons of Monetary Experience, page 131.
• 17Ibid., page 131, and Monetary Reconstruction, page 133.
• 18See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.
• 19For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 20What 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.
• 21This 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.
• 22Op. cit., page 171.
• 23No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
• 24“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.
• 25Trade and Credit, London, 1928, page 98.
• 26Currency and Credit, 3rd ed., London, 1928, page 153.