Any attempt at a general proof, within the compass of a short essay, of the assertion that non-monetary theories of the trade cycle inevitably suffer from a fundamental deficiency, appears to be confronted with an insuperable obstacle by reason of the very multiplicity of such theories. If it were necessary for our purpose to show that every one of the numerous disequilibrating forces which have been made starting points for trade cycle theories was, in fact, nonexistent, then the conditions of our success would, indeed, be impossible of fulfillment; for not only would it be almost impossible to deal with all extant theories but no conclusive answer could result, seeing that we should still have to reckon with a new and hitherto unrefuted crop of such theories in the future. Moreover the existence of most of the interconnections elaborated by the various trade cycle theories can hardly be denied, and our task is rather their coordination in a unified logical structure than the development of entirely new and different trains of thought. In fact, it is by no means necessary to question the material correctness of the individual interconnections emphasized in the various non-monetary theories in order to show that they do not afford a sufficient explanation. As has already been indicated in the first chapter, none of them is able to overcome the contradiction between the course of economic events as described by them and the fundamental ideas of the theoretical system which they have to utilize in order to explain that course. It will, therefore, be sufficient to show, by examination of some of the best-known theories, that they do not answer this fundamental question; nor can they ever do so by their present methods and by reference to the circumstances they now regard as relevant to trade cycle theory. When, however, the question is answered on different lines, viz., by reference to monetary circumstances, it can be shown that the elements of explanation adduced by different theories lose their independent importance and fall into a subordinate position as necessary consequences of the monetary cause.
It is rather difficult to select the main types of trade cycle theory for this purpose, since we have no theoretically satisfactory classification. The latest attempts at such classifications, by Mr. W.M. Persons, Professor W.C. Mitchell, and Mr. A.H. Hansen, show that the usual division, which relies on external features and hardly touches the solution of fundamental problems, gives far too wide a scope for arbitrary decisions. As Professor Löwe has correctly emphasized (and as should be obvious from what has been said above), the only classification that could be really unobjectionable would be one that proceeded according to the manner in which such theories explain the absence of the “normal course” of economic events, as presented by static theory. In fact, the various theories—as we shall hope to show later—make no attempt whatever to do this. As there is, therefore, no classification that would serve our purpose, our choice must be more or less arbitrary; but by choosing some of the best-known theories and exemplifying the train of thought to which our objection particularly applies, we should be able to make the general validity of the latter sufficiently clear. The task is made rather easier by the fact that there does exist today, on at least one point, a far-reaching agreement among the different theories. They all regard the emergence of a disproportionality among the various productive groups, and in particular the excessive production of capital goods, as the first and main thing to be explained. The development of theory owes a real debt to statistical research in that, today, there is at least no substantial disagreement as to the thing to be explained.
There is, however, a point to be emphasized here. The modern habit of going beyond the actual crisis and seeking to explain the entire cycle, suffers inherently from the danger of paying less and less attention to the crucial problem. In particular, the attempt to give the object of the theory as neutral a name as possible (such as “industrial fluctuations” or “cyclical movements of industry”) threatens to drive the real theoretical problem more into the background than was the case in the old theory of crisis. The simple fact that economic development does not go on quite uniformly, but that periods of relatively rapid change alternate with periods of relative stagnation, does not in itself constitute a problem. It is sufficiently explained by the adjustment of the economic system to irregular changes in the data—changes whose occurrence we always have to assume and which cannot be further explained by economic science. The real problem presented to economic theory is: Why doesn’t this adjustment come about smoothly and continuously, just as a new equilibrium is formed after every change in the data? Why is there this temporary possibility of developments leading away from equilibrium and finally, without any changes in data, necessitating a change in the economic trend? The phenomena of the upward trend of the cycle and of the culminating boom constitute a problem only because they inevitably bring about a slump in sales—i.e., a falling-off of economic activity—which is not occasioned by any corresponding change in the original economic data.
II
The prevailing disproportionality theories are in agreement in one respect. They all see the cause of the slump in the fact that, during the boom, for various reasons, the productive apparatus is expanded more than is warranted by the corresponding flow of consumption; there finally appears a scarcity of finished consumption goods, thus causing a rise in the price of such goods relatively to the price of production goods (which amounts to the same thing as a rise in the rate of interest) so that it becomes unprofitable to employ the enlarged productive apparatus or, in many cases, even to complete it. At present there is hardly a recognized theory that does not give this idea, which we only sketch for the moment, a decisive place in its argument, and we should therefore be well advised to begin by seeing how the various theories try to deal with the phenomenon in question. Apart from the monetary theories, which, as will be shown later, can only be considered satisfactory if they explain that phenomenon, there are two groups of explanations that can be entirely disregarded. In the first place there is nothing to be gained from an examination of those theories that seek to explain cyclical fluctuations by corresponding cyclical changes in certain external circumstances, while merely using the unquestionable methods of equilibrium theory to explain the economic phenomena that follow from these changes. To decide on the correctness of these theories is beyond the competence of economics. In the second place, it is best, for the moment, to exclude from consideration those theories whose argument depends so entirely on the assumption of monetary changes that when the latter are excluded no systematic explanation is left. This category includes Professor J. Schumpeter, Professor E. Lederer, and Professor G. Cassel, and to a certain extent Professor W.C. Mitchell and Professor J. Lescure. We shall have to consider later, with regard to this category, how far it is theoretically permissible to treat these monetary interconnections as determining conditions on the same footing as the other phenomena used in explanation.
It is, of course, impossible at this point to go into the peculiarities of all types of theory, as worked out by their respective authors. We must leave out of account the forms in which the various explanations are presented, and confine ourselves to certain underlying types of theory that recur in a number of different guises. Inevitably, this treatment of contemporary theories must fail to do full justice to the intellectual merits exemplified in each; but for the purposes of this chapter—that is, to show the fundamental objections to which all non-monetary theories of the trade cycle are open—this somewhat cursory and imperfect treatment may be enough.
We may begin our demonstration by pointing out that all those forms of disproportionality theory with which we have to deal here rest on the existence of quite irregular fluctuations of “economic data” (that is, the external determining circumstances of the economic system, including human needs and abilities). From this assumption, they try to explain in one way or another that the fluctuations in consumption or some other element in the economic system occasioned by these changes are followed by relatively greater changes in the production of production goods. These wide fluctuations in the industries making production goods bring about a disproportionality between them and the consumption industries to such an extent that a reversal of the movement becomes necessary. It is not, therefore, the simple fact of fluctuation in the production of capital goods (which is certainly inevitable in the course of economic growth) which has to be explained. The real problem is the growth of excessive fluctuations in the capital goods industries out of the inevitable and irregular fluctuations of the rest of the economic system, and the disproportional development, arising from these, of the two main branches of production. We can distinguish three main types of non-monetary theories explaining the exaggerated effect of given fluctuations on capital goods industries. The most common, at the moment, are those explanations that try to show that, on account of the technique of production, an increase in the demand for consumption goods, whether expected or actual, tends to bring about a relatively larger increase in the production of goods of a higher order, either generally or in a certain group of these goods. Hardly less common, and differing only in appearance, are explanations that seek to derive these augmented fluctuations from special circumstances (non-monetary in character) arising in the field of savings and investment. Finally, as a third group, we must mention certain psychological theories, which, for the most part, have however no pretension to rank as independent explanations and which merely reinforce other arguments, and are open to the same objections as the two other main types.
III
We shall mention only the most important of our objections to the first type, which is the easiest to discuss from this point of view. It is common to so many economists that it is hardly necessary to mention particular representatives. The simplest way of deductively explaining excessive fluctuations in the production of capital goods is by reference to the long period of time that is necessary, under modern conditions, for preparing the fixed capital goods which enable the expansion of the productive process to take place. According to a widely held view, this circumstance alone is enough to make every increase in the sales of consumption goods, whether brought about by an intensification of demand or by a fall in the costs of production, capable of bringing about a more-than-proportional increase in the production of intermediary goods. This is explained either by the individual producer’s ignorance of what his competitors are doing, or—as is common in American writings—by the “cumulative effect” of each change in the sale of consumption goods on the higher stages of production. Owing to circumstances that will be explained later, the leading idea in all these types of explanation is that the long period which, with the present technique of production, elapses between the beginning of a productive process and the arrival of its final product at the market, prevents the gradual adjustment of production to changes in demand through the agency of prices and makes it possible, from time to time, for an excessively large supply to be thrown on the market. This idea is supported by another, which however, can be independently and more widely applied; that is, that every change in demand, from the moment of its appearance, propagates itself cumulatively through all the grades of production, from the lowest to the highest. This cumulative effect arises because at each stage, besides the change that would be appropriate to the actual shift in demand, another change arises from the adjustment of stocks and of productive apparatus to the alteration in market conditions. An increase in the demand for consumption goods will not merely call forth a proportional increase in the demand for goods of a higher order: the latter will also be increased by the amount needed to raise current stocks to a proportional level, and, finally, by the further amount by which the requirements for producing new means of production exceed those for keeping the existing means of production intact. (For instance, an extension of 10 percent, in one particular year, in the machinery of a factory that normally renews 10 percent of its machinery annually, causes an increase of 100 percent in the production of machinery—i.e., a given increase in the demand for consumption goods occasions a tenfold increase in the production of production goods.) This idea is offered as an adequate reason not only for the relatively greater fluctuations in production-goods industries but also for their excessive expansion in periods of boom. Similarly, the extensive use of durable capital equipment in the modern economy is often singled out for responsibility. Industries using heavy equipment are prone to excessive expansion in boom periods because small increments in this equipment are impossible; expansion must necessarily take place by sudden jerks. Once the new equipment is available, on the other hand, the volume of production has little influence on total costs, which go on even if no production takes place at all. New inventions and new needs, however, although they are often adduced as explaining the accelerated and excessive growth of capital goods industries, cannot be dealt with on the same footing. They only represent a special group of the many possible causes from which the cumulative processes described above may originate.
IV
There is virtually no doubt that all these interconnections, and many others that are given prominence in various trade cycle theories and which similarly tend to disturb economic equilibrium, do actually exist; and any trade cycle theory that claims to be comprehensively worked out must take them into consideration. But none of them get over the real difficulty—namely: why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late? They all try to explain this phenomenon by a further, usually tacit, assumption, which one of the advocates of these theories, Mr. C.O. Hardy, has himself put forward as their common idea, by which, in my opinion, he brings out with the utmost clarity their fundamental weakness. He states that all those theories that are based on the length of the production period under modern technical conditions agree in regarding these conditions as a source of difficulty to producers in adjusting production to the state of the market; producing, as they must, for a future period, the market possibilities of which are necessarily unknown to them. He then emphasizes that in general it is the task of the price mechanism to adjust supply to demand; he thinks, however, that this mechanism is imperfect, if a long period has to lapse between production and the arrival of the product at the market, because
prices and orders give information concerning the prospective state of demand compared with the known facts of the present and future supply, but they give no clue to the changes in supply which they themselves are likely to cause.
He tries to show how periodic over- and underproduction may result from an increase in demand acting as an incentive to increased production. He here states explicitly what others assume tacitly, and thus his exposition completely gives away the question-begging nature of all such arguments. For he holds that under free competition, in the case considered, more and more people try to profit by the favorable situation, all ignoring one another’s preparations, and “no force intervenes to check the continual increase in production until it reflects itself in declining orders and falling prices.” In this statement (according to which the price mechanism comes into action only when the products come on to the market, while, until then, producers can regulate the extent of their production solely according to the estimated total volume of demand) the fundamental error that can be shown to recur in all these theories is plainly revealed. It arises from a misconception of the deliberations that regulate the entrepreneur’s actions and of the significance of the price mechanism.
If the entrepreneur really had to guide his decisions exclusively by his knowledge of the quantitative increase in the total demand for his product, and if the success of economic activity were really always dependent on that knowledge, no very complicated circumstances would be needed to produce constant disturbances in the relation between supply and demand. But the entrepreneur in a capitalist economy is not—as many economists seem to assume—in the same situation as the dictator of a socialist economy. The protagonists of this view seem to overlook the fact that production is generally guided not by any knowledge of the actual size of the total demand, but by the price to be obtained in the market. In the modern exchange economy, the entrepreneur does not produce with a view to satisfying a certain demand—even if that phrase is sometimes used—but on the basis of a calculation of profitability; and it is just that calculation that will equilibrate supply and demand. He is not in the least concerned with the amount by which, in a given case, the total amount demanded will alter; he only looks at the price he can expect to get after the change in question has taken place. None of the theories under discussion explains why these expectations should generally prove incorrect. (To deduce their incorrectness from the fact that overproduction, arising from false expectations, causes prices to fall, would be mere argument in a circle.) Nor can this generalization be theoretically established by any other method. For so long, at least, as disturbing monetary influences are not operating, we have to assume that the price that entrepreneurs expect to result from a change in demand or from a change in the conditions of production will more or less coincide with the equilibrium price. For the entrepreneur, from his knowledge of the conditions of production and the market, will generally be in a position to estimate the price that will rule after the changes have taken place, as distinct from the quantitative changes in the total volume of demand. One can only say, as to this prospective price of the product concerned, that it is just as likely to be lower than the equilibrium price as to be higher and that, on the average, it should more or less coincide, since there is no reason to assume that deviations will take place only in one direction. But this prospective price only represents one factor determining the extent of production. The other factor, no less important but all too often overlooked, is the price the producer has to pay for raw materials, labor power, tools and borrowed capital—i.e., his costs. These prices, taken together, determine the extent of production for all producers operating under conditions of competition; and the producer’s decisions as to his production must be guided not only by changes in expectations as to the price of his product, but also by changes in his costs. To show how the interplay of these prices keeps supply and demand, production and consumption, in equilibrium, is the main object of pure economics, and the analysis cannot be repeated here in detail. It is, however, the task of trade cycle theory to show under what conditions a break may occur in that tendency toward equilibrium which is described in pure analysis—i.e., why prices, in contradiction to the conclusions of static theory, do not bring about such changes in the quantities produced as would correspond to an equilibrium situation. In order to show that the theories under discussion do not solve this problem, and only as far as is necessary for this purpose, we shall now study the most important of the interconnections which bring about equilibrium under the assumptions of static theory.
V
We may attempt this task by asking what kind of reactions will be brought about by the original change in the economic data that is supposed to cause the excessive extension of the production of capital goods, and how, in such cases, a new equilibrium can result. Whether the original impetus comes from the demand side or the supply side, the assumption from which we have to start is always a price—or rather an expected price—that renders it profitable under the new conditions to extend production. As stated above, we can assume—since none of the theories in question give any reason to the contrary—that this expected price will approximate the new equilibrium price. We can assume, that is, that if the impetus is a fall in unit costs, the producer will consider the effects of an increased supply; if the impetus is an increase in demand, he will consider the increase in the cost per unit following the increase in the quantity produced. The existence of a general misconception in this respect would require a special explanation, and unless this is to rest on a circular argument, it can only be accounted for by a monetary explanation, which we cannot consider at this point.
Now the length of time required to produce modern means of production cannot induce a tendency to an excessive extension of the productive apparatus; or, more accurately, any such tendency is bound to be effectively eliminated by the increase in price of the factors of production. Thus we cannot give a sufficient explanation for the occurrence of the disproportionality in these terms. This becomes obvious as soon as we drop the assumption that the price mechanism begins to function only from the moment at which the increased supply comes on the market, and consider that whenever the price obtainable for the finished product is correctly estimated, the adjustment of the prices of factors of production must ensure that the amount produced is limited to what can be sold at remunerative prices. The mere existence of a lengthy production period cannot be held to impair the working of the price mechanism, so long, at any rate, as no additional reason can be given for the occurrence of a general miscalculation in the same direction concerning the effect of the original change in data on the prices of the products. We must next inquire what truth there is in the alleged tendency toward a cumulative propagation of the effect of every increase (or decrease) of demand from the lower to the higher stages of production. The arguments given below against this frequently adduced theory must serve at the same time to refute all other theories based on similar technical considerations, for space will not permit us to go into every one of these, and the reader can be trusted to apply the same reasoning as is employed in this demonstration to all similar explanations—such as those based on the necessary discontinuity of the extension of productive apparatus. Does the cumulative effect of every increase in demand represent a new price-determining factor, as a result of which prices, and therefore quantities produced, will be different from those needed to achieve equilibrium? Is the regulating effect of prices on the extent of production really suspended by the fact that when turnover increases merchants try to increase stocks, and manufacturers to extend production? If the increase in the prices of production goods were the only counterbalancing factor to set against the increase in the demand for these goods, it would still be possible for more investments to be undertaken than would prove permanently profitable. According to the view we are considering, there will be an increase in the quantity of factors of production demanded at any price, as compared with the equilibrium situation, and therefore it would appear possible that at every price at which producers still think they can profitably make use of this quantity, investments will be undertaken to an unwarrantable extent.
This way of stating the position, however, entirely overlooks the fact that every attempt to extend the productive apparatus must necessarily bring about, besides the rise in factor prices, a further checking force: viz., a rise in the rate of interest. This greatly strengthens the effect of the rise in factor prices. It makes a greater margin between factor prices and product prices necessary just when this margin threatens to diminish. The maintenance of equilibrium is thus further secured.
For we must not forget that not only the volume of current production, but also the size at any given moment of the productive apparatus (including stocks, which cannot be omitted) is regulated through prices, and especially—apart from the above-mentioned prices for goods and services—by the price paid for the use of capital, that is, interest. Whatever particular explanation of interest we may accept, all contemporary theories agree in regarding the function of interest as one of equalizing the supply of capital and the demand arising in various branches of production. Until some special reason can be adduced why it should not fulfill this function in any given case, we have to assume, in accordance with the fundamental thesis of static theory, that it always keeps the supply of capital goods in equilibrium with that of consumption goods. This assumption is just as indispensable, and just as inevitable, as a starting point, as the main assumption that the supply of and demand for any kind of goods will be equilibrated by movements in the prices of those goods. In our case, when we are considering a tendency to enlarge the productive apparatus and the size of stocks, this function must be performed in such a way as to increase the rate of interest, and hence the necessary margin of profit between the price of the products and that of the means of production. This, however, automatically excludes that part of the increase in the demand for productive goods, which would have been satisfied despite the increase in their prices if the rise in the rate of interest had not taken place. None of the various trade cycle theories based on some alleged peculiarity of the technique of production can even begin to explain why the equilibrium position, determined by the various above-mentioned processes of price formation, should be reached at a different point from where it would be without these peculiarities.
Now as regards the prices of goods and services used for productive purposes, there seems to be no reason why they should not fulfill their function of equilibrating supply and demand. For supply and demand are here in direct relation with one another, so that any discrepancy which may arise between them, at a given price must, directly and immediately, lead to a change in that price. Only when we come to consider the second group of prices (those paid for borrowed capital or, in other words, interest) is it conceivable that disturbances might creep in, since, in this case, price formation does not act directly, by equalizing the marginal demand for and supply of capital goods, but indirectly, through its effect on money capital, whose supply need not correspond to that of real capital. But the process by which divergences can arise between these two is left unexplained by all the theories with which we have hitherto dealt. Yet before going on to see how far interest may present such a breach in the strict system of equilibrium as may serve to explain cyclical disturbances, we must briefly examine the explanation offered by the second important group of non-monetary theories, which attempt to explain the origin of periodical disturbances of equilibrium purely through the phenomena arising out of the accumulation and investment of saving.
VI
The earlier versions of these theories start from the groundless and inadmissible assumption that unused savings are accumulated for a time and then suddenly invested, thus causing the productive apparatus to be extended in jerks. Such versions can be passed over without further analysis. For one thing, it is impossible to give any plausible explanation why unused savings should accumulate for a time; for another thing, even if such an explanation were forthcoming, it would provide no clue to the disproportional development in the production of capital goods. The fact that the mere existence of fluctuations in saving activity does not in itself explain this problem is realized (in contrast to many other economists) by the most distinguished exponent of these theories, Professor A. Spiethoff. This is plain from his negative answer to the analogous question, whether in a barter economy an increase in saving can create the necessary conditions for depression. Indeed, it is difficult to see how spontaneous variations in the volume of saving (which are not themselves open to further economic explanation, and must therefore be regarded as changes of data) within the limits in which they are actually observed can possibly create the typical disturbances with which trade cycle theory is concerned.
Where, then, according to these theories, may we find the reason for this genesis of disequilibrating disturbances in the processes of saving and investment? We will keep to the basis of Spiethoff ’s theory, which is certainly the most complete of its kind. We may disregard his simple reference to the “complexity of capital relations,” for it does not in itself provide an explanation. The main basis of his explanation is to be found in the following sentence: “If capitalists and producers of immediate consumption goods want to keep their production in step with the supply of acquisitive loan capital, these processes should be consciously adjusted to one another.” But the creation of acquisitive loan capital ensues independently of the production of intermediate goods and durable capital goods; and conversely, the latter can be produced without the entrepreneur knowing the extent to which acquisitive capital (i.e., savings) exists and is available for investment; and thus there is always a danger that one of these processes may lag behind while the other hastens forward. This reference to the entrepreneur’s ignorance of the situation belongs, however, to that category of explanation that we had to reject earlier. Instead of showing why prices—and in this case, particularly, the price of capital, which is interest—do not fulfill, or fail to fulfill adequately, their normal function of regulating the volume of production, it unexpectedly overlooks the fact that the extent of production is regulated on the basis not of a knowledge of demand but through price determination. Assuming that the rate of interest always determines the point to which the available volume of savings enables productive plant to be extended—and it is only by this assumption that we can explain what determines the rate of interest at all—any allegations of a discrepancy between savings and investments must be backed up by a demonstration why, in the given case, interest does not fulfill this function.38 Professor Spiethoff, like most of the theorists of this group, evades this necessary issue—as we shall see later—by introducing another assumption of crucial importance. It is only by means of this assumption that the causes that he particularly enumerates in his analysis gain significance as an explanation; and therefore it should not have been treated as a self-evident condition, to be casually mentioned, but as the starting point of the whole theoretical analysis.
VII
Before going into this question, however, we must turn our attention to the importance in trade cycle theory of errors of forecast, and, in connection with these, to a third group of theories that have not been considered up to now: the psychological theories. Here, as elsewhere in our investigations, we shall only be concerned with those theories that are endogenous—i.e., which explain the origin of general under- and overestimation from the economic situation itself, and not from some external circumstance such as weather changes, etc. As we said earlier, fluctuations of economic activity that merely represent an adjustment to corresponding changes in external circumstances present no problem to economic theory. The various psychological factors cited are only relevant to our analysis insofar as they can cast light on its central problem: that is, how an overestimate of future demand can occasion a development of the productive apparatus so excessive as automatically to lead to a reaction, unprecipitated by other psychological changes. Those who are familiar with the most distinguished of these theories, that of Professor A.C. Pigou (which, owing to lack of space, cannot be reproduced here)39 will see at once that the endogenous psychological theories are open to the same objections as the two groups of theories we have already examined. Professor Pigou does not explain why errors should arise in estimating the effect, on the price of the final product, of an increase in demand or a fall in cost; or, if the estimate is correct, why the readjustment of the prices of means of production should not check the expansion of production at the right point. No one would deny, of course, that errors can arise as regards the future movements of particular prices. But it is not permissible to assume without further proof that the equilibrating mechanism of the economic system will begin its work only when the excessively increased product due to these mistaken forecasts actually comes on the market, the disproportional development continuing undisturbed up to that time. At one point or another, all theories that start to explain cyclical fluctuations by miscalculations or ignorance as regards the economic situation fall into the same error as those naïve explanations that base themselves on the “planlessness” of the economic system. They overlook the fact that, in the exchange economy, production is governed by prices, independently of any knowledge of the whole process on the part of individual producers, so that it is only when the pricing process is itself disturbed that a misdirection of production can occur. The “wrong” prices, on the other hand, which lead to “wrong” dispositions, cannot in turn be explained by a mistake. Within the framework of a system of explanations in which, as in all modern economic theory, prices are merely expressions of a necessary tendency toward a state of equilibrium, it is not permissible to reintroduce the old Sismondian idea of the misleading effect of prices on production without first bringing it into line with the fundamental system of explanation.
VIII
It is perhaps scarcely necessary to point out that all the objections raised against the non-monetary theories, already cited in our investigations, are justified by one particular assumption that we had to make in order to examine the independent validity of the so-called “real” explanations. In order to see whether the “real” causes (whose effect is always emphasized as a proof that monetary changes are not the cause of cyclical fluctuations) can provide a sufficient explanation of the cycle, it has been necessary to study their operation under conditions of pure barter. And even if it were impossible to prove fully that, under these conditions, no non-monetary explanation is sufficient, enough has been said, I think, to indicate the general trend of thought which would refute all theories based exclusively on productive, market, financial, or psychological phenomena. None of these phenomena can help us to dissolve the fundamental equilibrium relationships that form the basis of all economic explanation. And this dissolution is indispensable if we are to protect ourselves against objections such as those outlined above.
If the various theories comprised in these groups are still able to offer a plausible explanation of cyclical fluctuations, and if their authors do not realize the contradictions involved, this is due to the unconscious importation of an assumption incompatible with a purely “real” explanation. This assumption is adequate to dissolve the rigid reaction mechanisms of barter economy, and thus makes possible the processes described; but for this very reason it should not be treated as a self-evident condition, but as the basis of the explanation itself. The condition thus tacitly assumed—and one can easily prove that it is in fact assumed in all the theories examined above—is the existence of credit which, within reasonable limits, is always at the entrepreneur’s disposal at an unchanged price. This, however, assumes the absence of the most important controls that, in the barter economy, keep the extension of the productive apparatus within economically permissible limits. Once we assume that, even at a single point, the pricing process fails to equilibrate supply and demand, so that over a more or less long period, demand may be satisfied at prices at which the available supply is inadequate to meet total demand, then the march of economic events loses its determinateness and a range of indeterminateness appears, within which movements can originate leading away from equilibrium. And it is rightly assumed, as we shall see later on, that it is precisely the behavior of interest, the price of credit, which makes possible these disturbances in price formation. We must not, however, overlook the fact that the range of indeterminateness thus created is “indeterminate” only in relation to the absolute determinateness of barter economy. The new price formation, together with the new structure of production determined by it, must in turn conform to certain laws, and the apparent indeterminateness does not imply unfettered mobility of prices and production. On the contrary, every departure from the original equilibrium position is definitely determined by the new conditioning factor. But if it is the existence of credit that makes these various disturbances possible, and if the volume and direction of new credit determine the extent of deviations from the equilibrium position, it is clearly not permissible to regard credit as a kind of passive element, and its presence as a self-evident condition. One must regard it rather as the new determining factor whose appearance causes these deviations and whose effects must form our starting point when deducing all those phenomena that can be observed in cyclical fluctuations. Only when we have succeeded in doing this can we claim to have explained the phenomena described.
The neglect to derive the appearance of disproportionality from this condition, which must be assumed in order to keep the argument within the framework of equilibrium theory, leads to certain consequences that are best exemplified in the work of Professor Spiethoff. For, in his theory, all-important interconnections are worked out in the fullest detail and none of the observed phenomena remains unaccounted for. But he is not able to deduce the various phenomena described from the single factor which, by virtue of its role in disturbing the interrelationships of general equilibrium, should form the basis of his explanation. At each stage of his exposition he calls in experience to back him up and to show what deviations from the equilibrium position actually occur within the given range of indeterminateness. Consequently it never becomes clear why these phenomena must always occur as they are described; and there always remains a possibility that, on some other occasion, they may occur in a different way, or in a different order, without his being able to account for this difference on the basis of his exposition. In other words, the latter, however accurately and pertinently it describes the observed phenomena, does not qualify as a theory in the rigid sense of the word, for it does not set out those conditions in whose presence events must follow a scientifically determined course.
IX
Although there is no doubt that all non-monetary trade cycle theories tacitly assume that the production of capital goods has been made possible by the creation of new credit, and although this condition is often emphasized in the course of the exposition,40 no one has yet proved that this circumstance should form the exclusive basis of the explanation. As far as strict logic is concerned, it would not be impossible for such theories to make use of some other assumption that is capable of dissolving the rigid interrelationships of equilibrium and, therefore, of forming the basis of an exact theoretical analysis. But once we assume the existence of credit in our explanation, we can attack the problem by seeing how far the objections raised earlier against the validity of the various theories under a barter economy are invalidated when the new assumption is made. Then we shall also be able to determine whether this assumption has necessarily to be made in the usual form, or whether it only represents a special instance of a far more widely significant extension of the assumptions of elementary theory.
The question we have to ask ourselves is: what new price-determining factor is introduced by the assumption of a credit supply that can be enlarged while other conditions remain unchanged—a factor capable of deflecting the tendency toward the establishment of equilibrium between supply and demand? Whether we necessarily accept the answer that, to my mind, is the only possible one depends on whether we agree with a certain basic proposition, which could only be briefly outlined here and whose full proof could only be given within the framework of a complete system of pure economics; namely, the proposition that, in a barter economy, interest forms a sufficient regulator for the proportional development of the production of capital goods and consumption goods, respectively. If it is admitted that, in the absence of money, interest would effectively prevent any excessive extension of the production of production goods, by keeping it within the limits of the available supply of savings, and that an extension of the stock of capital goods that is based on a voluntary postponement of consumers’ demand into the future can never lead to disproportionate extensions, then it must also necessarily be admitted that disproportional developments in the production of capital goods can arise only through the independence of the supply of free money capital from the accumulation of savings, which in turn arises from the elasticity of the volume of money. Every change in the volume of means of circulation is, in fact, an event to be distinguished from all other real causes, for the purpose of theoretical reasoning; for, unlike all others, it implies a loosening of the interrelationships of equilibrium. No change in “real” factors, whether in the amount of available means of production, in consumers’preferences, or elsewhere, can do away with that final identity of total demand and total supply on which every conception of economic equilibrium is based. A change in the volume of money, on the other hand, represents, as it were, a one-sided change in demand, which is not counterbalanced by an equivalent change in supply. Money, being a pure means of exchange, not being wanted by anyone for purposes of consumption, must by its nature always be re-exchanged without ever having entirely fulfilled its purpose; thus when it is present it loosens that finality and “closedness” of the system which is the fundamental assumption of static theory, and leads to phenomena that the closed system of static equilibrium renders inconceivable.
Together with the “closedness” of the system there necessarily disappears the interdependence of all its parts, and thus prices become possible which do not operate according to the self-regulating principles of the economic system described by static theory. On the contrary, these prices may elicit movements that not only do not lead to a new equilibrium position but actually create new disturbances of equilibrium. In this way, through the inclusion of money among the basic assumptions of exposition, it becomes possible to deduce a priori phenomena such as those observed in cyclical fluctuations. One instance of these disturbances in the price mechanism, brought about by monetary influences—and the one which is most important from the point of view of trade cycle theory—is that putting out of action of the “interest brake” which is taken for granted by the trade cycle theories examined above. How far this circumstance forms a sufficient basis for a theory of the trade cycle is a problem of the concrete elaboration of monetary explanation, and will therefore be dealt with in the next chapter, where we shall examine how far existing monetary theories have already tackled those problems that are relevant to a theory of the trade cycle.
X
The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations—a condition not fulfilled by any theory based exclusively on “real” processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships. All the phenomena that become possible only as a result of this relaxation must then be explained—as consequences of the particular elements, through whose inclusion among the elementary assumptions they become explicable within the framework of general theory. In place of such a theoretical deduction, we often find an assertion, unfounded on any system, of a far-reaching indeterminacy in the economy. Paradoxically stated as it is, this thesis is bound to have a devastating effect on theory; for it involves the sacrifice of any exact theoretical deduction, and the very possibility of a theoretical explanation of economic phenomena is rendered problematic.
Similar objections of a general nature must be leveled against another large group of theories that we have not yet mentioned. This necessary tendency toward a state of equilibrium, it is not permissible to reintroduce the old Sismondian idea of the misleading effect of prices on production without first bringing it into line with the fundamental system of explanation.
VIII
It is perhaps scarcely necessary to point out that all the objections raised against the non-monetary theories, already cited in our investigations, are justified by one particular assumption that we had to make in order to examine the independent validity of the so-called “real” explanations. In order to see whether the “real” causes (whose effect is always emphasized as a proof that monetary changes are not the cause of cyclical fluctuations) can provide a sufficient explanation of the cycle, it has been necessary to study their operation under conditions of pure barter. And even if it were impossible to prove fully that, under these conditions, no non-monetary explanation is sufficient, enough has been said, I think, to indicate the general trend of thought which would refute all theories based exclusively on productive, market, financial, or psychological phenomena. None of these phenomena can help us to dissolve the fundamental equilibrium relationships that form the basis of all economic explanation. And this dissolution is indispensable if we are to protect ourselves against objections such as those outlined above.
If the various theories comprised in these groups are still able to offer a plausible explanation of cyclical fluctuations, and if their authors do not realize the contradictions involved, this is due to the unconscious importation of an assumption incompatible with a purely “real” explanation. This assumption is adequate to dissolve the rigid reaction mechanisms of barter economy, and thus makes possible the processes described; but for this very reason it should not be treated as a self-evident condition, but as the basis of the explanation itself. The condition thus tacitly assumed—and one can easily prove that it is in fact assumed in all the theories examined above—is the existence of credit which, within reasonable limits, is always at the entrepreneur’s disposal at an unchanged price. This, however, assumes the absence of the most important controls that, in the barter economy, keep the extension of the productive apparatus within economically permissible limits. Once we assume that, even at a single point, the pricing process fails to equilibrate supply and demand, so that over a more or less long period, demand may be satisfied at prices at which the available supply is inadequate to meet total demand, then the march of economic events loses its determinateness and a range of indeterminateness appears, within which movements can originate leading away from equilibrium. And it is rightly assumed, as we shall see later on, that it is precisely the behavior of interest, the price of credit, which makes possible these disturbances in price formation. We must not, however, overlook the fact that the range of indeterminateness thus created is “indeterminate” only in relation to the absolute determinateness of barter economy. The new price formation, together with the new structure of production determined by it, must in turn conform to certain laws, and the apparent indeterminateness does not imply unfettered mobility of prices and production. On the contrary, every departure from the original equilibrium position is definitely determined by the new conditioning factor. But if it is the existence of credit that makes these various disturbances possible, and if the volume and direction of new credit determine the extent of deviations from the equilibrium position, it is clearly not permissible to regard credit as a kind of passive element, and its presence as a self-evident condition. One must regard it rather as the new determining factor whose appearance causes these deviations and whose effects must form our starting point when deducing all those phenomena that can be observed in cyclical fluctuations. Only when we have succeeded in doing this can we claim to have explained the phenomena described.
The neglect to derive the appearance of disproportionality from this condition, which must be assumed in order to keep the argument within the framework of equilibrium theory, leads to certain consequences that are best exemplified in the work of Professor Spiethoff. For, in his theory, all-important interconnections are worked out in the fullest detail and none of the observed phenomena remains unaccounted for. But he is not able to deduce the various phenomena described from the single factor which, by virtue of its role in disturbing the interrelationships of general equilibrium, should form the basis of his explanation. At each stage of his exposition he calls in experience to back him up and to show what deviations from the equilibrium position actually occur within the given range of indeterminateness. Consequently it never becomes clear why these phenomena must always occur as they are described; and there always remains a possibility that, on some other occasion, they may occur in a different way, or in a different order, without his being able to account for this difference on the basis of his exposition. In other words, the latter, however accurately and pertinently it describes the observed phenomena, does not qualify as a theory in the rigid sense of the word, for it does not set out those conditions in whose presence events must follow a scientifically determined course.
IX
Although there is no doubt that all non-monetary trade cycle theories tacitly assume that the production of capital goods has been made possible by the creation of new credit, and although this condition is often emphasized in the course of the exposition,40 no one has yet proved that this circumstance should form the exclusive basis of the explanation. As far as strict logic is concerned, it would not be impossible for such theories to make use of some other assumption that is capable of dissolving the rigid interrelationships of equilibrium and, therefore, of forming the basis of an exact theoretical analysis. But once we assume the existence of credit in our explanation, we can attack the problem by seeing how far the objections raised earlier against the validity of the various theories under a barter economy are invalidated when the new assumption is made. Then we shall also be able to determine whether this assumption has necessarily to be made in the usual form, or whether it only represents a special instance of a far more widely significant extension of the assumptions of elementary theory.
The question we have to ask ourselves is: what new price-determining factor is introduced by the assumption of a credit supply that can be enlarged while other conditions remain unchanged—a factor capable of deflecting the tendency toward the establishment of equilibrium between supply and demand? Whether we necessarily accept the answer that, to my mind, is the only possible one depends on whether we agree with a certain basic proposition, which could only be briefly outlined here and whose full proof could only be given within the framework of a complete system of pure economics; namely, the proposition that, in a barter economy, interest forms a sufficient regulator for the proportional development of the production of capital goods and consumption goods, respectively. If it is admitted that, in the absence of money, interest would effectively prevent any excessive extension of the production of production goods, by keeping it within the limits of the available supply of savings, and that an extension of the stock of capital goods that is based on a voluntary postponement of consumers’ demand into the future can never lead to disproportionate extensions, then it must also necessarily be admitted that disproportional developments in the production of capital goods can arise only through the independence of the supply of free money capital from the accumulation of savings, which in turn arises from the elasticity of the volume of money. Every change in the volume of means of circulation is, in fact, an event to be distinguished from all other real causes, for the purpose of theoretical reasoning; for, unlike all others, it implies a loosening of the interrelationships of equilibrium. No change in “real” factors, whether in the amount of available means of production, in consumers’preferences, or elsewhere, can do away with that final identity of total demand and total supply on which every conception of economic equilibrium is based. A change in the volume of money, on the other hand, represents, as it were, a one-sided change in demand, which is not counterbalanced by an equivalent change in supply. Money, being a pure means of exchange, not being wanted by anyone for purposes of consumption, must by its nature always be re-exchanged without ever having entirely fulfilled its purpose; thus when it is present it loosens that finality and “closedness” of the system which is the fundamental assumption of static theory, and leads to phenomena that the closed system of static equilibrium renders inconceivable.
Together with the “closedness” of the system there necessarily disappears the interdependence of all its parts, and thus prices become possible which do not operate according to the self-regulating principles of the economic system described by static theory. On the contrary, these prices may elicit movements that not only do not lead to a new equilibrium position but actually create new disturbances of equilibrium. In this way, through the inclusion of money among the basic assumptions of exposition, it becomes possible to deduce a priori phenomena such as those observed in cyclical fluctuations. One instance of these disturbances in the price mechanism, brought about by monetary influences—and the one which is most important from the point of view of trade cycle theory—is that putting out of action of the “interest brake” which is taken for granted by the trade cycle theories examined above. How far this circumstance forms a sufficient basis for a theory of the trade cycle is a problem of the concrete elaboration of monetary explanation, and will therefore be dealt with in the next chapter, where we shall examine how far existing monetary theories have already tackled those problems that are relevant to a theory of the trade cycle.
X
The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations—a condition not fulfilled by any theory based exclusively on “real” processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships. All the phenomena that become possible only as a result of this relaxation must then be explained—as consequences of the particular elements, through whose inclusion among the elementary assumptions they become explicable within the framework of general theory. In place of such a theoretical deduction, we often find an assertion, unfounded on any system, of a far-reaching indeterminacy in the economy. Paradoxically stated as it is, this thesis is bound to have a devastating effect on theory; for it involves the sacrifice of any exact theoretical deduction, and the very possibility of a theoretical explanation of economic phenomena is rendered problematic.
Similar objections of a general nature must be leveled against another large group of theories that we have not yet mentioned. This group pays close attention to the monetary interconnections and expressly emphasizes them as a necessary condition for the occurrence of the processes described. But they fail to pass from this realization to the necessary conclusion; to make it a starting point for their theoretical elaboration, from which all other particular phenomena have to be deduced. To this group belongs the theory of Professor J. Schumpeter, and certain “underconsumption theories” notably that of Professor E. Lederer; and, similarly, the various “realistic” theories: that is, those that renounce any unified theoretical deduction, such as those of Professors G. Cassel, J. Lescure, and Wesley Mitchell. With regard to all these semi-monetary explanations, we must ask whether—once we have been compelled to introduce new assumptions foreign to the static system—it is not the first task of a theoretical investigation to examine all the consequences that must necessarily ensue from this new assumption, and, insofar as any phenomena are thus proved to be logically derivable from the latter, to regard them in the course of the exposition as effects of the new condition introduced. Only in this way is it possible to incorporate trade cycle theory into the static system that is the basis of all theoretical economics; and, for this very reason, the monetary elements must be regarded as decisive factors in the explanation of cyclical fluctuations. The contrast therefore can be reduced to a question of theoretical presentation, and it may even seem, when comparing these theories, that the matter of the express recognition of the monetary starting point is one of purely methodological or even terminological importance, having no bearing on the essential solution of the problem. But the same procedure that in one case may only lead to a lapse from theoretical elegance, breaking the unity of the theoretical structure, may in another case lead to the introduction of thoroughly faulty reasoning, against which only a rigid systematical procedure provides an effective security.
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