The Stock Market, Credit and Capital Formation

CHAPTEE XI

THE SUPPLY OF CAPITAL AND INDUSTRIAL FLUCTUATIONS

72. It has been pointed out a number of times in the previous chapters that too easy conditions in the capital market produced by an expansion of bank credit, cause industrial investments to be undertaken which in the course of time will most likely turn out to have been misdirected. It is not my purpose to give a complete description of the way in which this comes about. The process has been analysed in the writings of Wicksell,1 Mises,2 Hayek,3 and others. Hayek’s writings exerted much influence in stimulating the discussion of problems of price and interest theory as they relate to excesses and painful setbacks of investment. It is, however, useful for purposes of exposition to have in addition a simplified version which omits the complications of price and interest analysis, but pictures the way in which the supply of money capital affects the structure of production.

Why credit expansion is likely to lead to disproportionalities in production,—

—has been explained with reference to relative prices.

A simplified version may be attempted.

Cassel attempted to give something of the kind in his Theory of Social Economy. An “analysis of real capital . . . brings us back,” he says, “. . . to the real capital in existence at the beginning of the period and the capital disposal offered during the period, and, of course, to the other primary factors of production available during that same time.”4 This formulation evidently involves double counting if it counts the “capital disposal offered” and “the primary factors of production.” If we reduce the analysis to barter terms, all that we find are the “real capital in existence at the beginning of the period” and the “primary factors of production” which are assigned to the production of future output by working with, and adding to, the real capital previously in existence or by replacing real capital that has been used up. The “capital disposal offered” gives the producers command over these primary factors of production so that they can be used for carrying on roundabout processes of production. The “capital disposal” directs the factors of production into the time-consuming processes of production.5

Money capital directs productive services into roundabout processes of production.

In his total gross receipts for the products sold, an individual entrepreneur recovers, in liquid form, the cost of production invested in his output. If he wants to maintain the volume of output at the same level as before, he must reinvest the recovered cost, i.e., the liquidated investment of the preceding periods. Thus the money proceeds of the sale of his products represent money capital which the entrepreneur can use, if he finds it profitable, for the purpose of continuing production by buying capital goods (intermediate products) from other entrepreneurs and combining them with original factors of production (mostly the services of labour). The money capital which he reinvests is, in part, liquidated working capital and, in part, replacement allowance for fixed capital. When a surplus over these two is received in the total proceeds of production and when a part of such “net return” is saved (instead of consumed), the entrepreneur will be able to increase the scale of his operations. An increase in the supply of money capital which comes about in this way will not usually cause any painful or disturbing dislocation among the various stages of the production structure. Intermediate products and primary factors of production (labour and land) will, in this case, be used in stages that are more remote from consumption instead of in stages that are nearer to consumption. A decline in the supply of money capital, on the other hand, will usually give rise to disturbances (crises). This is because a sudden shift of means of production from the stages that are remote from consumption to the stages that are nearer to consumption would involve skipping several stages, and this is technically impossible.6 A diminution in the supply of money capital will cause a disruption in the process of production such that intermediate products produced in the stages of production remote from consumption will fail to find buyers, investments in the preceding stages will fail to be liquidated at the due date, and a glut will result in large parts of industry.

If the volume of production is to be maintained, all liquidated capital must be reinvested.

An increase in money capital may not disturb production processes;—

—a decrease in money capital is more likely to cause such disturbances.

73. This simplified version of a set of rather complicated relationships tells us that in every period the opportunities for making use of the real capital taken over from the previous period, and the possibility of directing into production the primary factors that are necessary to maintain a given production structure, are dependent on the amount of free money capital that is available. It follows that in order for production to be carried on at an unchanged level the free money capital supplied in each period must not fall below the amount supplied in the previous period.

A condition for the maintenance of an undiminished supply of money capital ready for investment is that the returns of production should always permit provision to be made for replacing the working capital that has been used up and the fixed capital that has depreciated. The entrepreneur must, therefore, be able to conduct his business on a paying basis and must not use more of his gross return for consumption purposes than allows his working capital and amortization capital to be reinvested at an undiminished figure. If, in addition to this, part of the net return, or parts of the earnings of labour, land, and capital, are invested (new savings), it is possible for longer roundabout methods of production to be undertaken. The new production cannot, however, be continued, or rather the volume of investment cannot be maintained at the higher level, in the next period unless the same dose of money capital is forthcoming—otherwise the increased production will not be taken over by the succeeding stage. And where the production structure has many stages, a dose of saved money capital which is supplied only once, and not continuously, may cause production processes to be started which cannot be continued.

Money capital must be applied in continuous doses at successive periods.

Savings supplied once instead of repetitively lead to mis-investment.

The fact that saving may have disturbing effects of the kind liable to cause a depression has been pointed out and explained in similar terms by Lampe7 and Hayek.8 These theories, however, have to be sharply distinguished from the Keynesian hoarding theory and the under-consumption theories of the Foster and Catchings’ style. Nobody will deny that saving, if it involves spontaneous or institutional hoarding, will lead to disturbances (as Keynes shows); what can be denied, however, is that intended saving always or even usually involves hoarding. The idea that saving is bound to produce a crisis, independently of hoarding, because it involves a restriction of consumption (as Foster and Catchings9 hold) is to my mind untenable. I mention these theories here only to bring out the contrast. The theory which I have presented, connecting up saving with disturbances, is of quite a different nature. The substance of this theory is that the saving process leads to an extension of the production structure which will be followed by a contraction associated with a crisis, if the saving is not continued (i.e., maintained and repeated) in the next period. It is not the saving itself which produces the disturbance but the decline in saving.

It is not saving which causes disturbances, but a decline in saving.

Discussions of the saving process often run in terms of a certain rate of saving or rate of capital accumulation. A given percentage rate of increase in saving would be reckoned on the basis of a constantly increasing stock of capital and would mean, in consequence, an increase in the absolute dose of new saving from period to period. We have said that the condition for the maintenance of a given level of production, or for the continuance of a production process that has once been started, is merely that there should be a constant absolute volume of current saving.1

It has long since been realized that consumption of capital diminishes the potential output of society in the future. Our simple theoretical scheme serves to show that a process of capital consumption may be accompanied right at the beginning by disturbances of the economic system leading to a crisis. The diminution in the supply of money capital due to inadequate or declining allocations to replacement funds makes it impossible for some sections of the producers’ goods industries to carry on. The outward sign of this will be a falling off in sales and a contraction of production in the producers’ goods industries.

Capital consumption affects not only future output, but may lead to immediate contraction and crisis.

It is important to note that measures which are designed to raise consumption, and which have been very popular instruments of economic policy during the last two decades, may have the same effect. If the increase in consumption takes place at the expense of capital formation (even if net capital formation is still positive but smaller than before), it may lead to disturbances in the structure of production such as have been described.2 The mere diminution in the supply of new money capital may be sufficient to cause a depression.

Over-consumption may cause a depression.

74. The entire amount of money capital supplied does not all appear on the credit market. When an entrepreneur sets aside the replacement allowances necessary to make good for the depreciation of his fixed capital, he will normally reinvest these funds in his own business. These funds have to be counted as part of the supply of money capital available for investment even though they do not pass through the capital market. The entrepreneur will retain this money capital in his own business so long as that business shows sufficient profit. Furthermore, a major part of the new capital deriving from business profits may be used in the firm of its origin, with the result that even newly saved capital does not always pass through the capital market. This is what is usually called self-finance of industry, or corporate saving.

Not all of the money capital supplied passes through the capital market;—

—for instance, replacement allowances—

—and corporate savings—

—may meet demand at the place of their origin.

In those cases where the saver (or the person who provides the money capital) is not identical with the real investor, the money capital comes onto the market. A leading rôle in the organization of the loan market is, of course, played by the banks. As is well known, the banks do not confine their activities merely to the transferring of credits deriving from new savings and replacement funds; they grant other credits besides. No matter whether they do this by making advances or overdrafts, by discounting bills or by purchasing securities, they are providing purchasing power which has not been given up by anybody else beforehand. Part of the supply of money capital thus frequently is “created” credit. Opinions as to how large a part of the supply of money capital this represents, and as to what are its effects, are various. Cassel, for example, stated that the part of money capital that comes from “the issue of bank money” is very small in comparison to the supply of genuine savings.3 Schumpeter, on the other hand, took the creation of money capital by the banks as the essential factor for his Theory of Economic Development,4 and a number of authors have glorified the “creative” power of created credit. There is no doubt whatever that created bank credit is in fact a powerful agent in the shaping of economic changes. It has, however, been explained in many theories of the trade cycle, and especially in the credit theory developed by Wicksell and Mises, that these changes will usually take the form of cumulative-reversive movements.

Created credit is a part of the supply of money capital,—

—it functions as an agent of change,—

It is, of course, not the existence of bank credit, but its expansion, that is the agent of change. If, for example, the volume of credit outstanding amounts to x, this volume of credit will have exerted its effects at the time when it was created, but the continued existence of this amount, that is, the prolongation of the credits or their replacement by loans to other borrowers when they are repaid, will not set any new movements going. It is only when the banks expand their lending to x + n that we can talk about an inflationary supply of money capital to the extent of n.

—not through its existence, but through its expansion.

It will be clear at once that a single increase in inflationary bank credit means a single dose of new money capital and enables an expansion in the volume of production to take place which is liable to prove impossible to sustain in the very next period unless further doses of money capital follow. It is conceivable that a rise in voluntary saving might occur in the succeeding periods sufficient to take the place of the doses of money capital which had been provided in the first period by bank credit. In order for the production processes that were started with the aid of bank credit to be continued, it would be necessary for the volume of credit outstanding to remain at the increased level of x + n, and for the amount of voluntary saving per period to increase by n. This increased provision of voluntary savings in the periods succeeding the period of credit creation must not be confused with the provision of “forced saving” resulting from the investment of the created credit.

If an increased production volume is to be maintained a single dose of created credit must be succeeded by further doses or by a corresponding increase of voluntary saving.

Since there is nothing which would “automatically” call forth a sufficient increase in the level of voluntary saving, we have to conclude that the only way in which a sudden recession in the volume of production previously expanded by means of bank credit can be avoided is if there is a continual expansion of bank credit in the succeeding periods which will provide additional doses of inflationary money capital. Supposing that in the initial period bank lending had been increased from x to x + n, then the extension of production produced by that increase would require for its maintenance a further expansion of bank credit to x + 2n in the next period and to x + 3n in the third period. (It would even be necessary for the later doses to be increased in money volume in order to compensate for the accompanying price rise.) As soon, however, as the process of further credit inflation comes to a stop for any reason, then even if there is no credit contraction in an absolute sense, the total value of money capital available will be reduced compared with the previous period, and it will be impossible to maintain the productive activity at the level on which it was started. The cessation of the credit inflation will lead to lower sales and to the contraction of production in the stages of production remote from the consumption end, that is, in the producers’ goods industries. Probably it would be possible in many cases to ward off the crisis for some time longer by continuing the credit expansion, but the experiences of past inflations showed that nothing is gained by so doing.

The inflated rate of investment is likely to be maintained only by a steady, or increasing, rate of credit inflation.

The crisis breaks as inflation stops.

Our simplified model, based on the assumption of a constant supply of money capital, is sufficient to provide us with the main conclusions of the monetary theory of the trade cycle. Since all inflations must come to an end, since an everlasting process of inflation is impossible, an expansion of credit by the banks usually contains the seeds of a crisis. The roundabout production process can in the long run be maintained only at that level which is allowed by a permanent and steady flow of money capital supplied by voluntary saving.

The long-run rate of investment is determined by voluntary saving.

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However, I am leaving the text unchanged and confining further comment to this note. Even if the one-sided technical adaptability were non-existent, sufficient explanation of the disturbances could be found by reference to price relationships. I am thinking especially of the hypothesis that the marginal productivity of labour is raised by a lengthening of the production period (i.e., by an increase in the supply of capital) and is lowered by a shortening of the production period (i.e., a reduction in the supply of capital). One and the same volume of money will thus allow of higher equilibrium wage rates if it comes on to the market as money capital than if it comes on to the market as consumer purchasing power.