The Stock Market, Credit and Capital Formation

CHAPTER XVII

CONCLUSIONS

110. An evaluation of the results of our investigations may be facilitated by an abstract in catalogue form. The critic of this book should, however, not be tempted by such a handy digest to save time by skipping the first sixteen chapters and to form his opinion on the basis of the abstract. It is only intended to provide the reader who has struggled his way through the pages of this book with a “docket” which contains the shortest possible (and hence inexact) formulation of those of our theses which deviate from accepted doctrine or constitute controversial issues. Moreover, we include only those theses which are relevant to the general attitude toward the problems of the stock market, credit and capital formation; that is to say, we include only theses which may have practical-political significance rather than theses which constitute “intermediate products” of theoretical analysis, whatever may be their significance as instruments for arriving at definite findings.

An abstract of a selected list of issues is formulated here in—

111. 1. An investment of money capital which liquidates a previous investment of another person constitutes merely a transfer of funds.

—thirty-seven theses.

2. Consumption of profits and of liquidated investments may be at the expense of new capital formation, rather than at the expense of the old investment.

3. Money capital is “absorbed” where real investment takes place, i.e., where capital goods are produced. Not only the proceeds from sales of new securities but also those from sales of old securities may go into real investment.

4. Money capital may go into real investment, into consumption, into hoards (and cancellation of money), or into a chain of interpersonal transfers.

5. No additional money capital is needed for a rise in security prices.

6. Higher security prices, sometimes a symptom of an increased supply of investible funds, call forth issues of new securities and sales of old securities by industrial producers.

7. Abundant funds, especially those of inflationary origin, may not find ready outlets in real investment.

8. Extensive and lasting stock speculation by the general public thrives only on abundant credit.

9. Losses by stock-market speculators constitute no real capital losses to society.

10. An increase in stock-exchange turnover need not involve an increase in the demand for money on the part of stock-exchange members or of traders holding current accounts with stock - exchange members; the clearing mechanism may obviate any increase in payments.

11. Clearing balances need not be higher in times of high or rising stock prices or turnover than in times of low or falling stock prices or turnover. Clearing balances rise because of an uneven distribution of selling and buying among different brokers.

12. An increase in clearing balances can be settled without an increase in brokers’ bank balances through a faster turnover of existing volumes of bank balances and bank loans.

13. Customers’ brokerage deposits function in boom times as a peculiar type of “money” for the speculating public.

14. If speculators who sell ask for cheques from their brokers, and send cheques for their new purchases, bank deposits are tied up. However, widespread trading by the general public, involving long chains of cheque transactions, develops only in times of credit inflation.

15. A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

16. The volume of brokers’ loans tells us nothing about the amount of funds that have flowed onto the stock exchange. Brokers’ loans are increased through an excess of customers’ withdrawals over new deposits of funds.

17. Rising stock prices may lead to an increase in brokers’ loans through induced withdrawals of profits and proceeds.

18. Brokers’ loans rise also when sellers withdraw funds in order to loan them to brokers. The sum total of brokers’ loans may be a multiple of the funds actually involved.

19. If the seller lends, via the broker, to the buyer, brokers’ loans rise without requiring any funds or any bank credits. Brokers’ loans can be rapidly liquidated if call-money lenders buy securities from margin debtors.

20. Brokers’ loans which constitute credits by the seller to the buyer represent no funds which anybody might have used for anything else; neither the seller nor the borrower has liquid funds.

21. Bearish sellers may keep a liquid position not only by holding idle the balances received from bullish buyers but also by holding call-money claims. Large brokers’ loans do not reflect idle funds.

22. Capital gains are not money income to society and do not constitute investible funds.

23. Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.

24. An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

25. A “crash-proof” distribution of expanded credit is rather improbable. Both producers’ credit and consumers’ credit may create disproportionalities and lead to major disturbances. A price-stabilizing credit expansion may unstabilize the production structure.

26. Credit inflation is “healthy” if it compensates for deflation through current net hoarding, or for an increase in the number of holders of cash balances or in the number of “stopping-stations” in the money flow.

27. The use of credit for financing working capital does not assure “self-liquidation” or liquidation free of disturbance. For the economy as a whole circulating capital mostly constitutes long-term investment and, if the volume of production is to be maintained, even permanent investment.

28. Seasonal fluctuations in the producers’ capital demands are not manifestations of fluctuating capital requirements of the economy. The fluctuations came into being when temporarily liquid surplus cash balances were put to use.

29. Surplus cash balances in times of seasonally low inventories need not reflect seasonal unemployment of productive resources. The transition to a system of loaning out these temporary surplus funds may have inflationary effects.

30. Business surplus balances due to reduced production, and consumers’ surplus balances due to postponed consumption, if loaned out, represent genuine “transfer credit,” whereas surplus balances due to regular pulsations in the money flow, if loaned out, act like “created credit.”

31. Credit loaned out of surplus cash balances may make for monthly and seasonal easing and tightening of the money market.

32. The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn.

33. New short-term credits usually involve long-term investments for the economy as a whole. The banker cannot know the indirect uses of the funds which he lends. Careful selection of borrowers may protect the banker from losses but not the economy from immobilization.

34. The effect of a certain amount of bank loans may be the same whether they are given as stock-exchange credits or as direct commercial credits to industry. Qualitative credit control is effective only if it involves quantitative control.

35. If bank reserves are controlled by the monetary authorities, credit inflation should not be attributed to the stock-exchange boom. However, margin regulations may be an effective means of checking the expansion.

36. The stock exchange is the foremost market for industrial capital funds. Higher security prices mean cheaper capital for industry. It is not the stock market which competes with industry for funds, but rather industrial long-term credit which competes with industrial short-term credit.

37. The flow of money-market funds to securities markets may close the gap between long-term and short-term rates. If the funds spring from inflationary sources, a cumulative movement may emerge which can drive money-market rates above long-term rates.

112. The theses stated above were not, I repeat, selected because I considered them the representative results of my analysis. My object was to stress here those issues which a practical banker or politician might find interesting. Practical men are often sceptical of theoretical analysis. “That may be all right in theory, but is it true in practice?”, is one of their queries. And when they are assured that theory tries to explain things of the real world, another doubt arises concerning the value of the results of analysis: “That may all be so, but what does it teach us? How does it help us?”

Are the findings of theoretical analysis practically significant?

The practical man is inclined to regard scientific findings as valuable only if they are an aid to the formulation of definite plans of conduct, definite policies. It is usually forgotten that the findings of analysis cannot be instrumental in designing policies before the ends and goals, in the order of their relative importance, are decided upon. It is utterly useless, for example, to try to devise a policy of controlling stock-exchange credit before it is clear whether it is considered more important to avoid cyclical fluctuations in industry or to strive toward full industrial employment, or to save the public from losses through speculation or to secure cheap agricultural credit, or what not. Insight into the economics of the stock exchange will be needed for any of those policies, but economics alone cannot decide which policy is “the best.”

They cannot aid in the designing of policies before the ends and aims of policy are given.

It is, however, a very important task of economics to find out whether two or more of the “desired ends” are fully compatible with one another or whether they are alternatives between which we have to choose or, perhaps, whether they can all be accomplished only to a limited degree, forcing us to relinquish some part of one in order to obtain more of another. Problems of this sort are highly controversial. How much “stability” do we have to forgo in order to have more “progress? How much “recovery” can we create without risking too great a relapse? Many of the assumptions necessary for analysing these problems are of a political nature, and many points of a predominantly volitional character become unavoidable steps in the argument.

Various desired ends are often not compatible with one another.

Some years back, the avoidance of cyclical fluctuations was recognized as an objective of undisputed precedence. Years of economic stagnation changed the general attitude. To overcome the stagnation by all possible means became the objective, with the prevention of possible future set-backs as a minor consideration. Any policy of credit control, qualitative or quantitative, can, of course, be advocated and evaluated only as a part of the general policy toward the major ends.

Should credit control try to produce prosperity or to avoid fluctuations?

113. The dogma that one can avoid the downswing only by avoiding the upswing, which was widely held a few years ago, has recently fallen into disrepute. I still hold to that idea, not as a dogma, but as a statement of an extremely high “probability value.” I believe that the upswing breeds a host of disproportionalities in the production and price structure, which turn out to be untenable and result in a depression.

It seems that prosperity must inevitably be followed by depression.

To hold this view is not equivalent to upholding the postulate that an upswing ought to be avoided at all costs. Such a postulate would appear to be sensible only if there were another way of improving depressed economic conditions. Since such an alternative would most likely include cost reductions as a remedy for maladjustment, it has been termed the “deflationary route” toward re-employment. If one believes that route to be impassable for institutional or political reasons, or to be too stony and strenuous and unduly painful, one may take the position that the “inflationary route” is preferable in spite of its ups and downs. (Professor Röpke once contrasted the “sadistic trade cycle theory” with the “frivolous trade cycle theory”: the former recommending painful cost reductions without considering the solution through public loan expenditures, the latter recommending generous public spending without considering the solution through cost adjustments.)

Expansion is not necessarily the only way of improving economic conditions.

“Sadistic” versus “frivolous” trade cycle theories.

Those who believe, on the one hand, that distortions in the production set-up are likely to result from credit expansion, and on the other hand, that cost reductions would be both politically feasible and economically effective, would clearly oppose any inflationary policies. They would resist credit expansion whether it were demanded for the sake of stabilizing prices in a progressive economy, or for the sake of furthering production in a stagnating economy, or for the sake of pushing consumption or stimulating investment, or creating employment. Indeed, they would have to go further than the staunchest anti-inflationists, and suppress those merely momentary expansions of bank credit on days of massed payments, because these bank loans might support an expansion of loans out of existing surplus cash balances.1

Those who believe in the possibility and efficacy of cost reductions oppose inflation in any form.

114. It is hardly possible to devise, even in pure theory, a system which completely excludes all and every expansion of credit. The claims that a system of free banking would, in the long run, be less conducive to credit creation than a central reserve system, do not seem to be acceptable. The claims that a system of absolutely fixed, or rigidly managed, volumes of note and cheque deposit circulation would abolish all inflationary possibilities, are not tenable either; they are, to say the least, exaggerated. If, therefore, such radical reforms as the introduction of the 100% plan cannot guarantee full success in this respect,2 we shall have to content ourselves with the discrete exercise of the existing powers of monetary management.

No monetary system can be safe from “inflation”;—

—not even the 100% system.

Perfect monetary control would require perfect foresight. Short of this, monetary management needs at least the capacity of quickly recognizing what has been going on. In this regard, close observation of stock-exchange transactions, of stock prices and of stock-exchange credits is, I believe, of major importance, and can furnish significant clues for intelligent monetary management. In point of fact, the central banking authorities in various countries have been studying these records intently, especially since the middle of the twenties, and, relying on certain partly erroneous interpretations of their data, they were at times led to take more or less drastic action against stock-exchange credits. These actions and official charges and attacks against the stock exchange have evoked reactions on the side of “defenders” of the stock market. In these quarters, supported by recognized authorities in the field, it was held that it was none of the central banks’ business to watch, or, much less, to try to control, the stock exchange or stock-exchange credits.

Monetary control needs sensitive indices as guides.

Stork-exchange activity has been used as a guide,—

Many of the arguments against the intervention of the monetary authorities and against the “official” theories were correct. Yet, the suspicious attitude of the central authorities towards the excessive volume of stock-exchange credit was certainly justified. The official view that the stock exchange with its demand for credit was a dangerous competitor of trade and industry was, of course, untenable. And the official view that stock-exchange credit should be restricted but that, at the same time, credit in other forms should be allowed to expand, was wide open to criticism. But so much is certain that the volume of stock-exchange credits must not be ignored; it is important both per se and as a part of the total volume of bank loans. The volume of loans in conjunction with stock-market movements may be a valuable guide of credit policy.

—perhaps on the basis of false reasoning;—

—but the principle was justified.

The days when gold movements could be held to be the one and only guide of monetary management are definitely gone. Other indices have been accepted, or proposed, as “assistant guides” or even as chief guides. Their sensitiveness with respect to movements beyond the “zero point of inflation” varies with changing circumstances—unless one defines the zero point of inflation in terms of one of the indices (such as a certain price level or level of employment). If net inflation is defined as an expansion of the volume of money (and money substitutes) in excess of spontaneous net hoarding, and of requirements arising from an increased coefficient of money transactions (e.g., more stopping-stations in the money flow), then it is impossible to rely on any simple index that might work as an “inflatiometer.”3

Guides of monetary control are not equally sensitive to “inflation.”

Gold movements have never been a goo.d guide in that respect. Whenever expansion took place at a fairly even pace in all of the various gold standard countries, there would be no international gold movements to indicate that expansion. The foreign exchange market, though more sensitive than the gold flow, would likewise fail to record “parallel inflations” in the various countries. The commodity market and, in particular, the level of commodity prices, the most popular guide, fails to function as such, that is to say, fails to record credit inflation, when production techniques, or the productivity of resources, change—as they do almost continuously. The securities market, however, and in particular the level of security prices, would be likely to respond to an inflationary use of credit even when all the other indices failed to respond.4

Gold movement;—

—foreign exchange rates—

—and commodity price levels—

may fail to register inflation which is registered by security price levels.

The movement of the level of security prices would be indicative of inflation and deflation not per se but only in conjunction with other circumstances. Changes in the volume of stock-exchange credit would have to be watched in this connexion. It should be noted, however, that the volume of stock-exchange credit may rise without any funds flowing to or from the stock exchange, if sellers lend to buyers. On the other hand, borrowed bank funds may pass through the stock exchange and onto industry without any rise in the volume of stock-exchange credits, if the buyers have obtained loans from others than brokers. For these reasons the volume of all bank credits would have to be watched together with the movement of security prices and, moreover, together with the volume of security issues. The volume of security issues, however, may rise merely through flotations by investment trusts and holding companies without any new funds going to industry. On the other hand, borrowed funds may go into industry, via the stock market, without any new security issues, if industrial firms sell securities which they have previously carried among their assets. Thus, we see that none of the indices mentioned—security prices, stock-exchange credits, total bank credit, security issues—is fully reliable as evidence for or against the presence of inflation. Yet, if all of these indices show an upward (or downward) movement, the presumption is very strong that inflation (or deflation) in the sense defined is taking place, even if the level of commodity prices does not show the least upward (or downward) tendency.

Security prices should be watched together with stock exchange credits—

—and total bank credits as well as new security issues.

115. To regard stock-market data as an important guide of credit control is one thing; it is quite another thing to regard the stock market as an appropriate working point for credit control. One may accept the barometer-function of stock-market activity and yet prefer general discount policy, open-market policy and other measures affecting the excess reserves of commercial banks as the best means of credit control. On the other hand, one may belittle the stock market as a guide and yet accept discrimination against stock-exchange credit, margin regulations, and control of flotations as efficient means of credit control. In other words, one may believe that the stock market is both a good “compass” and a good “steering wheel” of monetary control, or one may believe the one without believing the other.5

The stock market is not only considered a good guide—

—but also a proper field of intervention by monetary authorities.

I am inclined to think that the stock market can serve both functions, but only in connexion with other guides and other mechanisms of control. This has just been made clear with respect to the guide function. As to the efficacy of credit control through securities-exchange control, it was pointed out in the previous chapters of this book that much depended on the degree of co-ordination between the particular control measures and general credit policy. Discrimination against brokers’ loans will hardly be successful during a runaway boom if, at the same time, the authorities choose to continue an easy-money policy. Yet the system now adopted in the United States seems to provide the monetary authorities with better checks against an inflationary inundation of the stock market than were at their disposal in the past. On the one hand, margin regulations can reduce the buying of securities with borrowed funds and, on the other hand, control over the issuing of new securities can severely restrict the effective demand for these funds. This two-handed control ought to be capable of preventing inflationary financing of private industry as long as the monetary authorities care to do so.

The present means of control seem to be effective checks on the inflationary financing of private industry.

The inflationary financing of the public budget is another matter.

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