§ 15. Money and Credit and the Cycle

The part played by changes on the money and credit side of the economic system has already come into prominence many times, and especially in the last section. It is in fact such an outstanding feature that a group of trade-cycle theorists who have recently become increasingly influential—the representatives of the monetary or credit theory of the trade cycle—see the ultimate causes of cyclical movements in the changes taking place during the cycle on the money and credit side, and they emphatically declare that cycles and crises are a mere monetary and credit phenomenon.⁶

That the part played by monetary factors must be very important is to be inferred from the mere observation that the upswing of the cycle is regularly marked by a price rise, in spite of the fact that it is at the same time a period of increasing production of goods, so that we should really expect a tendency to falling prices. It follows that the upward swing must be characterized either by a rise in the volume of money and credit or by an increase in the velocity of circulation or by both at once. This theoretical deduction is confirmed by experience. Conversely, the depression is apparently a period of diminished volume of money and diminished velocity of circulation of money (and we have for present purposes to include under this the so-called book money represented by movements in the demand deposits of the banks). Expressed in another more concise way: the upswing is to be envisaged as a kind of inflation and the depression as a kind of deflation. All that we experienced on a large scale in the postwar inflation in Germany is here repeated on a small scale just as the other way round we can look upon the post-war inflation period as one great boom period whose unavoidable end was continually postponed by new and stronger doses of the inflation drug. All that was observable in this record inflation we have only to reduce to a smaller scale in order to obtain the typical characteristics of every boom: the general rise in prices, the whetting of the spirit of enterprise and speculation, the unhealthy expansion of productive plant, the general desire to buy, the increase in the volume of business, the desire to get out of money into goods, the tendency to passivity in the trade balance, &c. That the present economic depression is conversely to be conceived of as a deflation has already become familiar to everybody.

This contention seems to contradict the well-known fact that the most recent American boom which sowed the seeds of the heaviest of all economic depressions was not characterized by a rise in the general price level. This was presumed to be a sign that no reaction was to be feared and that we could count on “eternal prosperity.” That this reaction has nevertheless followed, and in the most severe form, leads to the conclusion that the American boom of the years 1926-1929 was not very different in its essentials from an ordinary boom and that the inflationary expansion of the economic system can scarcely have been absent from it. In fact, although the volume of cash rose only slightly in that period, the volume of credit rose to an enormous extent. A rise in the general price level did not occur in spite of this enormous credit expansion for the reason that at the same time the prices of commodities were being pressed downwards by the fall in costs due to the progress of technique and organization. In other words: if at that time enormous quantities of additional credit had not been pumped into the American economic system, prices would have fallen considerably. The fall of average production costs in industry and agriculture realized in that period was so large that a rise in the price level was all the time prevented in spite of the fact that additional credits were always being pumped into circulation. The opinion that the credit inflation would thereby be rendered harm-less turned out to be fatal. To maintain stable a price level which in ordinary circumstances would have had to fall on account of a general lowering of production costs, amounts to the same thing as pushing prices up by an unconcealed credit inflation when production costs have remained unchanged. The important point is then not that the general price level rises, but simply the circumstance that additional quantities of money and credit are supplied to the economic system, calling forth dangerous disturbances in the structure of production. The monetary theory thus formulated is capable of explaining even the otherwise incomprehensible American boom. It is indeed the only trade-cycle theory which can really explain it satisfactorily.⁷ The conclusion then is that in order to set in motion the boom mechanism which undeniably leads to a breakdown, it is not at all necessary for there to be an absolute credit inflation (in the sense of an expansion of credit leading to a general rise in the prices of commodities) but that a relative credit inflation is quite sufficient.

The increase of money, which the monetary theory of the trade cycle designates as the cause of the upswing, is essentially an increase in credit money which comes from the central note-issuing banks and banks doing current-account deposit business. An understanding of the monetary theory of the cycle presupposes above all a knowledge of how such an increase of credit money—“credit creation”—can come about. This process cannot be described here in detail,⁸ but it may be more easily intelligible if we point out what an extremely large proportion of transactions are effected without the use of cash (cheques, clearing), that is by disposing over demand deposits (current accounts), so that a superstructure of credit is built on the cash basis. The size of this superstructure is dependent on the width of the cash basis and on liquidity considerations of the banks, and it can therefore be subject to substantial fluctuations. This means that our credit system is elastic and that within certain moderately wide limits it permits of arbitrary changes in the volume of credit money. These changes are according to the monetary theory of the cycle identical with the cyclical movements. Thus the volume of credit rises to the detriment of bank liquidity in the boom period and falls accompanied by an improvement in liquidity in the depression. The leading rôle in this connexion is usually played by the central note-issuing banks.

For a complete understanding of the monetary theory of the cycle it is essential to realize that the pivot of the whole mechanism is the rate of interest. In so far as the banks—led by the central note-issuing bank via its discount policy—lower or raise the rate of interest, there ensues an expansion or contraction of credit. The decisive factor is not the absolute height of the banks’ interest rate, but the discrepancy between this and that rate of interest (the real rate of interest in Wicksell’s sense⁹ or the equilibrium rate) which would establish itself if the volume of credit in the community were built up solely out of real savings and not out of additional credits besides. A credit inflation can therefore very well arise by the fact that the banks leave their interest rate unchanged or do not raise it far enough at a moment when the equilibrium rate in the economic system—which is only a fictitious figure reflecting roughly the average rate of profits anticipated from capital investment—has risen. This is, however, exactly what regularly happens in the boom period. If at the commencement of the boom the profit expectations of the economic system rise but the banks maintain their previous rate for credit advances or do not raise it sufficiently, then the automatic consequence is an increase in the demand for credit, owing to the widening of the gap between the rate of interest and profits on capital. In this case, therefore, no active intervention of the banks is necessary in order to call forth an increase in the demand for credit. It is sufficient if they do not follow or do not follow quickly enough the changes in average profit expectations (subjective real rate of interest). This is the situation that repeats itself with the beginning of every boom.

The credit expansion setting the boom going proceeds by way of the interest rate being “too low.” The too low interest rate invites a general increase in investment which then leads to the mechanism of the boom drifting on towards its ultimate débâcle as was described in the preceding section. At the same time the additional credits are the source out of which the increased capital needs of the boom are in the main satisfied. The chain of reasoning is now complete: the expansion of credit in the boom expressing itself in the too low interest rate leads to an over-expansion of the economic process and by introducing a general over-investment disrupts the equilibrium of the economic system. It allows more to be invested than is saved and makes available the necessary increase in money capital from credits which do not originate from savings but are created out of nothing through the banking system. The restriction of direct consumption necessary for every increase in investment which is undertaken voluntarily in the case of real savings, is here replaced by the shrinkage of consumption imposed by the (relative) price rise, consequent on the credit inflation, on all those whose incomes are not adjusted rapidly enough to the rise in prices (monetary forced saving).¹ Through the additional credit there is made possible a shift in the economic system in the direction of an expansion of production, the “carrying out of new productive combinations of factors of production” as Schumpeter puts it, and “room” is “squeezed out” for the production of new goods at the cost of consumption.

The demonstration that the credit expansion of the boom leads to over-investment provides at the same time a proof that the capital formation induced by credit creation, and the extension of production that it sets going, leads to a painful reaction expressing itself in the crisis and depression. This reaction can indeed be postponed by a further increase of the credit supply but only at the price of a corresponding aggravation of the ultimate reaction. An “eternal boom” is therefore out of the question. The whole process of economic advance is, it is true, given a sharp jerk forward in the boom, but only to spring back again in the crisis and depression. The crisis breaks in the moment when the power of credit creation of the banks can no longer keep up with the continually increasing capital requirements of the economic system: there takes place, so to speak, a race between these two factors in which the banking system must finally succumb unresistingly if it wants to maintain sufficient liquidity to meet the increasing demands of the system for cash in the boom. The central note-issuing bank usually gives the signal for this by raising its discount rate.

The statement that the immediate cause of the breakdown is the necessity for the banking system ultimately to defend its liquidity position against the continuously growing demand for additional credits, needs to be carefully interpreted. Thus stated, it gives the impression that the machinery of the boom comes to a halt for a mere technical reason, i.e., because of the monetary exigencies imposed by the gold standard. Many writers—even Wicksell himself is not entirely free from this error—have, indeed, contented themselves with this explanation given in purely monetary terms. But it is very unsatisfactory and far too narrow, for it leaves unanswered the question as to what will happen in a closed system without the “golden brake on the credit machine.” Is it not another curse of the gold standard (or of any other currency with international affiliations and stable exchange rates) that it condemns us to cut short the road to eternal prosperity and to strangle the boom when everything is going at its best? The answer to this is, of course, that the only alternative to the “golden brake” (or its equivalent) would be a fully fledged inflation which, if no other brake were in due course to be applied, would end where the German inflation ended, without avoiding the ultimate crash. This must be looked at against the background of the “real” mechanism of intensification (principle of acceleration) described at full length in the preceding section. For the same reason also an investment boom financed by authoritarian forced saving or, if such a thing is conceivable, by voluntary savings, could not escape the same fate since in this case also the progressively growing scale of investments would necessitate a progressively growing scale of savings until the saving capacity of the nation were exhausted and, consequently, a correspondingly painful readjustment became necessary. In other words, the monetary aspect of the breakdown of an investment boom financed by credit expansion (monetary forced saving) is only a special form of the breakdown corresponding to the monetary causation of the boom. To be sure, this special form is also the usual and typical form characteristic of our economic system, but for reasons already indicated it must not be forgotten that it is a species belonging to a larger genus. The monetary theory of business cycles—even apart from its limited validity—can claim to be no more than a sort of Euclidean geometry among other non-Euclidean geometries.

In spite of the keenness and acuteness with which it has been added to and refined in the last few years, this exposition of the monetary theory of the trade cycle still remains full of unsolved or not entirely satisfactorily solved problems. To these belongs first and foremost the question as to what causes the banks to embark again and again on a credit expansion: is it a matter, as Mises thinks, of the effect of a certain ideology, or, as Hayek believes, of a process into which the banks are forcibly drawn? The probability is that the latter of these two contentions is right, but this does not mean that no effective limitation of credit expansion and therewith of over-investment is possible.

To sum up : the central idea of the monetary theory of the trade cycle is that the periodic expansion of credit regularly brings about that dislocation of the economic process which expresses itself in over-investment and its consequences. It would be too much to contend that this is the only circumstance that can lead to an excessive increase of investment, but experience and reflection seem to show that this is undeniably the usual way in which the disruption of the economic equilibrium takes place. In this sense the monetary theory of the trade cycle is perhaps far superior to any other.

The monetary theory of business cycles has the invaluable merit of having exposed the real driving force without which the acceleration of investments in our economic system could not grow to such dimensions as lead up the hill of the boom and then down into the ditch of the crisis. But the account we have given so far of this theory would be not only incomplete but dangerously misleading if we did not finally introduce a very important modification which has a bearing on the present situation of advanced depression but which is omitted in most statements of this theory. All that has been said on credit expansion involving (by rising prices) forced savings, and leading in consequence to unhealthy boom conditions, is true only in the case of an inflationary credit expansion.

But surely not every credit expansion is inflationary. Whether a credit expansion is inflationary or not cannot be measured by the behaviour of the price level, as was demonstrated above by the example of the recent American boom. But the case is different if credit is being expanded when there is heavy unemployment of factors of production brought about by a previous credit deflation. This is exactly the situation of the advanced depression to-day. In this case the warnings against credit expansion are really ill-timed and dangerously apt to retard the process of recovery which can only be initiated by credit expansion breaking the vicious circle of depression and reabsorbing the idle factors of production. Since in this case the increase of purchasing power would be at once accompanied by an increase of current output, no appreciable rise of prices, no forced saving in the strict sense and, consequently, no over-investment would occur. Credit expansion would tap the unused reserves of productive capacity corresponding to the deficit of purchasing power brought about by deflation and hoarding, and thus open up a source of capital without the dangerous recourse to forced saving. In contrast to the inflationary credit expansion at the later stage of the upward swing when the reserves of productive capacity are exhausted, the earlier credit expansion is compensatory, not inflationary. This compensatory credit expansion must be clearly distinguished from the former, lest the merits of the monetary theory of business cycles be diminished by sweeping exaggerations of its austere message and its deserved reputation be compromised by unfounded implications. It is a distinction which will be understood better after the process of the advanced depression (secondary depression) has been explained. This will be our task in the next section.

The monetary theory of business cycles, as so far expounded, centres around the idea that it is variations in the quantity of circulating media which set the process of alternating booms and depressions in motion. The widening or the narrowing of the money stream in total is declared to be the essential thing. This very important aspect must not, however, lead us to overlook the possibility that the qualitative distribution of the money stream may also become an additional factor of instability. Thus it might not be unimportant whether the flood of additional credits goes into commercial loans, into the real estate markets, into the export or import business, into instalment selling, or into stock exchange speculation. This question gained great topical interest in connexion with the last American boom period up to 1929. It has been already remarked that this period is full of riddles, and one of these riddles is the fact that this period which has been followed by the severest crisis in history shows, on the whole, a price level which was slightly sagging rather than rising. How, then, can there have been inflation? The answer to this question has been given in the text above where it was stated that, owing to decreasing costs following on technical progress, prices would have fallen if an enormous amount of additional credit had not been pumped into the economic system. Hence there was inflation, even if only of the relative kind. But it can be perfectly well argued that the quantitative effect of this inflationary credit expansion was considerably aggravated by an abnormal qualitative distribution of credits. One case is the great expansion of instalment credits which gives the impression as if the Federal Reserve system was trying to administer the heroin not only per os but also per rectum. Indeed, hardly anything was more disquieting than the sanguine light-heartedness which prevailed at that time in the United States in the sphere of instalment selling. Another instance is the real estate market which was also grossly over-supplied with credits. The worst and most conspicuous case, however, was the stock-market speculation which was the leader on the road to disaster. For purposes of illustration, it may be mentioned that the volume of brokers’ loans rose from 1921 to 11929 by about 900 per cent.² It cannot possibly be denied that to conduct a large part of the additional credits over the securities market was a particularly dangerous procedure, for a number of reasons among which the disastrous international repercussions were not the least important. We may conclude, then, that the last American boom is a striking example of how the disequilibrating effects of variations in the volume of credit may possibly be greatly aggravated by peculiarities in the qualitative composition of the stream. But it must, of course, not be overlooked that this can only be an additional factor of instability and presupposes that an inflatory credit expansion is already going on. Without this, misdirections of credit can hardly give rise to a general economic disequilibrium. The same must be said about Irving Fisher’s “debt-deflation” theory of cycles³ which implies that it is over-indebtedness incurred during the boom which starts the crisis. Over-indebtedness could not occur without an inflationary expansion of credit, or, to be more explicit, it is only another word for it, since expansion of credit means, on the reverse side, expansion of debits, i.e., a growing volume of indebtedness.