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Business Cycles

The most charitable comment that can be made about the prevailing attitude of the economic profession toward the business cycle is that it demonstrates the overwhelming optimism of the human race. This present attitude can be described as follows:

(1)The true cause and mechanism of the cycle are as yet unknown.

(2)Nevertheless, it is agreed that the cycle seems to be a normal feature of the existing American economic system (and no doubt others as well), and that the business cycles can therefore be expected to continue, unless some major improvement in our understanding of the cause of the cycle takes place.

(3)Notwithstanding this general agreement that the cycles will continue, and that the true reasons for their origin and development are unknown, it is trustingly assumed that the government has the wisdom, initiative, and power to take sufficiently effective action against these unknown causes to prevent the low point of the cycle from ever again reaching depression levels.

During the depression era of the 1930’s, when the business cycle had no rival as the number one economic problem, it was freely admitted by the economists that their theoretical knowledge was totally unable to provide an explanation for the cause or mechanism of the cycle. Almost every one of the many books on the subject written during this period contains an explicit or tacit admission that the origin of depressions had everyone baffled. Hayek (1932)99 bluntly warns his colleagues that they must be “painfully aware” of how little they know about the force that they are attempting to control. King (1938)100 says that the “surprising suddenness” of the depression’s onset makes the “mystery especially baffling.” The use of three such words as mystery, surprising, and baffling in one short sentence is certainly revealing. Harwood (1939)101 “presumes” that no economist and few businessmen would expect that complete elimination of the cycle could ever be accomplished. Mitchell (1941),102 dean of business cycle theorists, clearly implies weariness and discouragement in the ranks when he counsels that business cycle theory need not be “given up in despair.”

How much progress have we made since then? William N. Loucks gave this assessment of the situation in 1961:

There is evidence that the business cycle is a product of the functioning of the institutions of a capitalist order. Just how these institutions, separately or in combinations, generate cyclical fluctuations of economic activity has not as yet been conclusively analyzed. Students of the business cycle, however, agree that its source must lie in entrepreneurial decisions in an environment that includes the profit motive, freedom of individual initiative, and competition.103

And what does this tell us? To be perfectly candid, isn't this simply taking 70 words to say “We don't know”? More recent discussions of the subject have no more to contribute. “Innumerable theories, none of them entirely satisfactory, have been advanced to explain the business cycle,” say Heilbroner and Thurow.104 Most economists sidestep the whole issue with such statements as “Today’s experts place little confidence in any single cause.”105 or “Most economists today believe in a synthesis or combination of external and internal theories,”36 or “Economists...tend to see variations in the rate of growth that tend to be induced by the dynamics of growth itself.”106

The truth is that little or no real progress has been made in this area since the 1930-1940 decade when the students of the cycle openly talked about giving up in despair. Since that time the economists are merely giving up more cheerfully. T. W. Swan, for example, is quite philosophic about the situation. “I suspect,” he says, “that the search for the theory of the trade cycle... is the economist’s equivalent of the search for the elixir of life or the philosopher’s stone.”107 Milton Friedman points out that the modern theorists have not actually advanced beyond the point reached by Mitchell. As he puts it, “the major difference between Mitchell’s theoretical discussion and modern discussion is in language rather than in substance. He uses none of the jargon we have grown so fond of -'propensities,' “multipliers,' “acceleration principle,' etc.-and he uses no mathematics.”108

The problems of the cycle have not been solved. What has happened is that the urgency has lessened, and the inherent optimism of the human race has had an opportunity to reassert itself. In 1940 the Great Depression was very close and very frightening. Some measure of recovery had been achieved, but there were still eight million unemployed, and it was painfully apparent that use of every known technique by a government willing and anxious to exert all of the power at its command had reduced neither the severity nor the duration of the depression. Indeed, there was much evidence to indicate that the actions taken by the government had actually delayed recovery. But by now the distressing experience of the thirties has receded into history, and the lessons that were presumably learned have been largely forgotten. Good intentions on the part of the authorities, which were so pathetically futile in the thirties, are now confidently expected to be able to triumph over any adversity. For instance, Arthur F. Burns, who had enough experience in government positions to know better, tells us, “It is reasonable to expect that our government will ordinarily be wise enough to move in sufficient time and on a sufficient scale to prevent recessions...from degenerating into severe or protracted slumps.”109

In the book previously quoted, W. N. Loucks recalls the philosophy of the “new era” in economics that was prevalent in the 1920’s and came to such a tragic end in 1929, and rather uneasily admits that “It is a fair question whether businessmen and academic economists again have been lulled by post-World War II prosperity, into a similar state of wishful thinking.”110 But he finally closes his eyes to the disagreeable facts of experience, and concludes that the current optimism is sound because (1) it is based on “those implications of Keynesian theory which have been almost unanimously accepted as sound by economists,” and (2) it does not rely upon automatic forces but upon the use of stabilization tools.

Neither of these arguments advanced by Loucks in support of his optimistic view of the situation can stand up under any kind of a critical examination. Even if Keynes’ theories were currently accepted by all economists, the volatility of economic ideas is too great to justify accepting those theories as conclusive. But Keynes’ theories are by no means “almost unanimously accepted” today. On the contrary, it is widely acknowledged that they have lost a great deal of ground in recent years.

So far as the second argument is concerned, it is quite obvious that as long as the economists admit that they do not know the causes of the business cycle, we cannot place any great reliance on the efficacy of the measures by which they propose to control it. This point was often emphasized even in the heyday of Keynesian economics. “It is exceedingly difficult.” J. E. Meade reported, “to decide to what extent any particular counter-measure to offset inflationary and deflationary developments would be successful in its objective.”111

In the light of the findings of the present investigation, it is clear that one of the principal factors responsible for this uncertainty is the way in which Keynes and his followers concentrated their attention on one particular phase of the situation to the virtual exclusion of everything else. According to Keynes, investment is the key factor in the problem. Alvin Hansen, one of the leading “interpreters” of Keynesian doctrine in its palmy days, asserts, without qualification, that “The cycle consists primarily in fluctuations in the rate of investment.”112 R. C. O. Mathews says essentially the same thing: “It is fluctuations in investment that are generally held to lie at the heart of the cycle.”113 Before going ahead with a general analysis of the cycle, it will therefore be advisable to examine this question of investment in more detail.

The first point that should be noted is that in the operation of the economic mechanism all goods are alike. Whether they are consumer goods or capital goods, durable goods or transient goods, is immaterial from the general standpoint. Regardless of their classification, they are all produced by the application of labor and the services of capital in some kind of a production process, and when they reach final form (that is, when intermediate products have been converted to final products) they are all sold to individuals, or their agents, in the goods markets. In these markets the buying is all done by the same kind of people and with the same kind of money. (It should be remembered that all buying of capital goods is financed by individuals, either by direct investment or by foregoing dividends to allow corporate earnings to be “plowed back.”)

In the successive phases of the business cycle the behavior of different classes of goods differs to a considerable degree, but neither the time order of the increases and decreases in demand for the various classes of goods nor the greater variability in the demand for durable goods has any fundamental significance. When unfavorable economic conditions cause consumers to reduce their buying of goods-in-general they naturally and logically start by eliminating purchases of those items that they can do without most easily; that is, capital goods, durable consumer goods, luxuries, etc. But since all goods are alike in the general economic process, these variations do not have any special effect on the general operation of the exchange mechanism. Those who have attributed great importance to the fluctuations in capital goods production, like Hansen, who called these ups and downs the essence of prosperity and depression114 have been misled by superficial appearances.

It is not a decrease in investment (purchase of capital goods) that is responsible for the downswing of the cycle; it is a decrease in the total money purchasing power entering the markets for the purchase of all goods that is at the root of the difficulty. The difference between “saving,” as defined by Keynes, and current investment goes into money storage, and it therefore constitutes one of the reservoir transactions which, according to the findings of this work, are the controlling factors that determine the course of the business cycle, but it is only one of many such transactions, not the determining factor, as the Keynesians would have us believe. Keynes’ conclusions on this subject are therefore only partially right, and like so many other half-truths, they lead to the wrong answers.

The relation of investment to saving, as Keynes defines the latter term for this particular purpose, has no significance in itself; it is only one of a number of equivalent phenomena. The net resultant of all of these equivalent items is the factor that determines the direction of movement of the price level and the business cycle. Keynes’ contention that regulation of investment is the key to control of the cycle is therefore erroneous. If investment happens to be unbalanced in the direction opposite to that of the net total of the reservoir transactions, which is likely to be the case at least part of the time, restoration of a balance between saving and investment would accentuate the unbalance of the economy as a whole rather than contributing to stability. Even where investment control happens to have the right direction, it is quite unlikely that the countercyclical measures can be applied on a sufficient scale to counteract the heavy surges that develop in some of the other reservoirs.

Another school of economic thought approaches the investment question from a different direction. In this view it is not the unbalance between saving and investment that is credited with causing the trouble; it is an “overproduction of capital goods relative on the one hand to the existing capital and on the other hand to the effective demand.” This, says Schumpeter, is “the explanation of the circumstance which cuts short the boom and brings about the depression.”115 As the economists of this school see the situation, investment adds to capacity, additional income is necessary in order to buy the products of the additional capacity, and if the income is not forthcoming, the capacity must remain idle. Oddly enough, Galbraith, who usually stands shoulder to shoulder with anyone who worries about a lack of demand, turns the argument upside down in this case, and becomes concerned about the possibility that the increased investment will add purchasing power in the form of wages, etc., before the added capacity is in operation to meet the added demand.”116

Some economists express concern over the possibility that so many new factories may be built that some of them cannot be utilized and will remain idle or partially idle. This is simply a case of making mountains out of molehills. Too much productive capacity in general will be possible only when general overproduction is possible, and our trouble now and as far as we can see into the future is too little production, not too much. The worst that can happen, therefore, is that too much productive capacity of some particular nature may be built-too many fast food restaurants, for instance. This is, of course, a loss to the community, in that it sacrifices the gain that could have been made if the same resources had been applied to the construction of a more useful productive plant. It should be emphasized, however, that this is the only unfavorable result of the overbuilding. An unproductive investment of this kind has no detrimental effect on economic stability, and it does not lessen employment, since jobs that never existed cannot be lost. It simply leaves the whole economic system just where it was before.

Careful investigation by the Brookings Institution and others has revealed that the overcapacity that appears to be present in many industries is more apparent than real. It is either the result of current operation of the economic system as a whole at less than maximum production, or it is due to the need for sufficient capacity to meet peak demands when they occur. But even if we do concede that an unnecessary factory or other facility may be built now and then, the only losers are the investors, and we cannot legitimately shed any tears over their misfortune. Bearing the risks of business is one of the functions which they have undertaken to perform, and for which they are being compensated.

Abandonment of a productive facility because of inability to find a productive use for it is the economic equivalent of consumption, and it has exactly the same effect on the economy of the individual and the economy of the community as a whole. If an individual loses $50,000 because of an investment in a failed business enterprise, both he and the community are in the same position as if he had spent the $50,000 on additional consumption by himself or his family. It would be preferable to channel the investment into usable facilities rather than into unprofitable ones, to be sure, because the community would then gain from the transaction, but in any event, the community suffers no actual loss.

All of these misconceptions of the role of investment in the modern economy are products of the confusion that has been generated in economics by what Galbraith calls “the intellectual repeal of Say’s Law.”117 and its replacement by the concept of an autonomous demand. The fear of a temporary excess of purchasing power is equally as groundless as the fear of a shortage. It is the investment itself, the purchase by individuals of the factory and its equipment that offsets the payments to individuals for the labor and services of capital required in building the factory and fabricating the equipment. The commodities which the factory will eventually produce play no part in this equilibrium. When their production finally begins, this production will create the purchasing power required for buying the commodities that are produced, nothing more. In order to avoid getting tangled up in these investment fallacies, all that is necessary is to bear in mind that the production of buildings, machinery, and other capital goods creates the full amount of purchasing power necessary to buy these capital goods-no more, no less-in exactly the same way that the production of consumer goods creates the right amount of purchasing power to buy those goods in the markets.

In view of all of the existing confusion as to the origin of the business cycle and the nature of the effects produced by each of the elements that enter into the situation, the present complacency regarding the ability of the government to meet whatever emergencies may arise is both unrealistic and hazardous, as Dudley Dillard pointed out some years ago in the following statement:

This appears a strange and dangerous illusion into which we have fallen-the illusion of economic stability. Although actual events have been little influenced during the past twenty years by Keynesian economics, we now implicitly put our faith in the conscious application of this type of policy to save us from the fate which has characterized capitalistic development with increasing intensity during the past century and a half. We have the arrogance to assume that from now on we shall do what has never been done before...Such faith in human intelligence is admirable but hardly justified from experience.118

The results of this present study show that the government does, indeed, have plenty of effective tools for controlling the business cycle. But the study also shows that many of the measures which currently occupy prominent places in the proposed control programs will have no effect on the cycle when the emergency arrives and they are put into operation. Even worse, some of these measures will actually have the opposite of the desired effect, and will impede recovery from a depression, rather than facilitate it. Under the circumstances if will be nothing short of a miracle if the net effect of government action is sufficient to halt a major depression when some evenT comparable to the 1929 stock market crash turns the natural downward swing of the cycle into an economic catastrophe.

One of the important factors in this situation is that massive movements such as great depressions require massive remedies. Whatever action is taken has to be sufficiently powerful to reverse, or at least halt, the downward trend. Merely slowing the decline does no good. It may even be harmful, in that it tends to lengthen the depression period. But when no one knows whether the proposed remedies will work or not, neither the government nor the general public is likely to have enough confidence in any particular remedy to permit applying it on the necessary massive scale. In all probability, the actual procedure will be to try a little of this and a little of that, just as was done in the 1930 depression, and the same failure to achieve satisfactory results is practically inevitable.

The economy in its present condition could be compared to a vehicle which has a full set of controls, but with no identification of the devices for operating those controls, and no outside view, so that there are no means of determining whether it is on the right course, other than the shocks that are felt when rough ground is encountered, and no way of knowing just which controls should be operated to produce a specified action, if some action seems to be required. In such a situation the obvious needs are to provide a window-some means to enable seeing where the vehicle is and where it is headed-and to determine the effects that are produced by each of the control devices, so that actions can be taken of exactly the right kind to keep the vehicle on the desired course.

In the preceding chapters of this work we have produced the equivalent of a window, and have identified the controls of the economic mechanism. We have shown that the requirement for maintaining a stable economy is to keep the flow of money purchasing power entering the goods market equal to that leaving the production market, and we have further shown that the method by which this can be accomplished-the only method that will produce the desired result-is to maintain a balance between the total inflow into and the total outflow from the reservoirs of money and credit that exist in connection with the purchasing power stream. The control must be related to the total reservoir transactions. Any attempt to base a control procedure on only one factor-investment, money supply, or whatever it may be-is automatically doomed to failure, as the measures undertaken in carrying out such a control policy will not have the correct magnitude, nor will they necessarily have the right direction. If the factor being controlled is moving contrary to the movement of the net total of the reservoir transactions, which can easily happen, the control measures will be harmful rather than helpful.

It is quite evident that the business cycle is simply a money inflation, as defined in Chapter 12, followed by a corresponding deflation. All that was said in Chapter 12 with respect to money inflation, its causes, and its remedies, is applicable to the alternate inflations and deflations that we call the business cycle. “It would be satisfying to discover a general cause of economic fluctuations, a single source of the uneven heartbeat of the economy,”119 says Lloyd Reynolds. Well, here it is. The movement of money into and out of the reservoirs is that “single source,” that “general cause of economic fluctuations.”

In view of the rather elementary nature of the explanation developed in this study, it seems almost incredible that the economic profession should have experienced so much difficulty in analyzing the cycle and its causes. The presence of reservoirs in connection with the money purchasing power stream is obvious to anyone who looks carefully at the economic process, and it is equally clear that the mere existence of uncontrolled reservoirs of this kind must inevitably lead to economic fluctuations. It is only natural, however, that the explanation developed herein should suffer from its very simplicity. There will be a tendency to feel that the answer to a long-standing problem of this kind cannot be so simple and obvious. For this reason it appears advisable to go into more detail concerning the mechanism of the cycle, so that there may be no question but that the reservoir theory furnishes an explanation that agrees with actual experience even down to the smallest particular.

”There are two main things to be explained,” according to Reynolds. “First, after the economy has started moving up or down, why does it build up momentum and keep going in the same direction for a considerable period of time? Second, and more difficult, why does the movement reverse itself after a while... Why doesn't the expansion continue indefinitely?”119 Once the action of the reservoirs is clearly understood, the answers to both of these questions are practically self-evident.

Let us begin our consideration of the cycle at a point where the system is in equilibrium, where the net reservoir transactions are momentarily at zero, and market price is therefore equal to production price. While such a condition of equilibrium could theoretically occur at any volume of production, in actual practice, as matters now stand, it will coincide with a production somewhat below the maximum. Such a balanced condition, however, does not persist for any extended period in the absence of a specific program for maintaining the balance. Soon some change takes place in the reservoir levels, either in one direction or the other. Let us assume for purposes of the analysis that in this particular case credit transactions increase, and the active money purchasing power stream is swelled by withdrawals from the reservoirs. This raises the market price level. The addition to the money flow passes on to the producers, and goes partly to increasing volume and partly to increasing production price, in accordance with the principles developed in Chapter 11. The larger volumes of goods and money purchasing power flow back to the markets, and if the reservoir withdrawals have ceased, equilibrium between production and the markets is reestablished at these higher levels of production and prices.

At this stage human reactions enter the picture. The rise in employment and production has improved general economic conditions for both producers and worker-consumers. While the latter, in their capacity as consumers have to pay somewhat higher prices, this is more than offset by the fact that in their capacity as workers they have the benefit of a favorable employment situation. The producers find a good demand for their products, and as long as the reservoir withdrawals continue, their profit margins are above normal. (When prices stabilize at the higher levels, this secondary advantage disappears.) Confidence then prevails, and the ensuing actions of both consumers and producers with respect to the controllable features of the economy, are influenced by this spirit of confidence.

Here is the first place in the entire study where it has been necessary to give any consideration to human behavior. Thus far the analysis has been confined to developing principles which take the form of statements that if certain economic actions are taken, then certain results will follow. At this point we find it useful to extend the scope of these principles by taking note of the fact that mass reactions of human beings to certain stimuli are just as amenable to exact mathematical and logical treatment as purely physical relations. We can state with the same degree of certainty that if certain conditions prevail, then certain mass actions by human beings will result.

Of course, we have been told that human actions are too unpredictable for mathematical treatment, but when we examine the situation closely we find that the difference between individual economic actions and individual physical actions is not so great after all. It is true that the individual human beings who constitute the fundamental economic units have a certain field in which they can exercise the privilege of choice between various possible economic actions, and this choice is individually unpredictable. But the actions of the ultimate units of the physical world are also unpredictable-de facto, if not de jure. We cannot predict the actions of an individual molecule any more than those of an individual person. Indeed, there is much support for a “principle of indeterminacy” which holds that there is an inherent uncertainty about physical phenomena that is impossible to resolve. But that which is only a probability so far an individual is concerned becomes almost a certainty for a group of individuals, and this is equally as true in human activities as it is in the physical realm. We cannot predict the life span of an individual by any of the means at our command, but from our actuarial tables we can forecast with considerable accuracy the number of individuals out of any sizeable group that will die within a specified period.

In the economic world, as well as in the physical world, individual uncertainty can be converted into group certainty through the application of the probability principles. The conclusions which we reach concerning the mass actions of unpredictable human beings can be just as exact as the conclusions that we reach concerning the mass actions of individually unpredictable molecules, providing that we use equally accurate methods in arriving at those conclusions. When we find from observation and statistical analysis that a rising price level, together with the secondary effects that accompany this rise, induces a spirit of confidence that results in reservoir withdrawals, this does not mean that every individual will react in this manner. It means the the net reaction of all individuals in the economy will be as indicated.

Let us now look at each of the important reservoirs to see how they are individually affected by the optimistic attitude. The principal contributor to the unbalancing of the system is credit. In no other way can the flow of purchasing power to the markets be more heavily augmented or more drastically reduced, and nowhere does the effect of confidence or lack of confidence show up more quickly. When business is on the upswing both the demand for and the supply of credit are above normal, and the money purchasing power stream is swelled by heavy withdrawals from the credit reservoirs.

Hand in hand with credit goes the rise in the valuation of existing assets. There is a popular misconception that this reduces the flow of consumer purchasing power to the markets; that much of the available purchasing power is used during boom times to raise the prices of land, stocks and bonds, or other capital assets in the possession of individuals. This is not correct. These assets are purchasing power in themselves, and exchanging them for circulating purchasing power only changes the ownership of the two forms of purchasing power at the same economic location. Every exchange of money for other assets by one consumer is also an exchange of these other assets for money by some other consumer, and consequently there is just as much money and just as large amount of the other assets in the hands of consumers in general after an exchange of this kind as there was before the exchange, regardless of the price at which the sale was consummated. A higher price increases the amount of money transferred, but it does not alter the final result, as transfer of money between consumers has no effect on the total amount of money in the possession of consumers in general, and hence no effect on the availability of money purchasing power for buying currently produced goods (Principle IV). Increases in the prices of existing goods in the hands of consumers finance themselves. Expressing this in another way, we have:

Principle XIII:All consumer purchasing power must be used for the purchase of goods from producers; it cannot be used for the purchase of goods already in the hands of consumers, or for raising the prices of such goods.

This point is worth emphasizing, as a misunderstanding of the facts with respect to transactions involving existing capital assets is responsible for much fallacious reasoning in current economic literature. It is another of those items which the orthodox approach to economic relations fails to clarify, and it is therefore not surprising that the work of many analysts has been seriously affected by this error. For example, the economists of the Brookings Institution carried out some detailed studies of the effect of distribution of income on the general economic situation, in the course of which they concluded that when the current volume of savings exceeds the requirements for new capital construction, the excess is taken up in various ways, including the purchase of existing securities or bidding up the prices of these securities.120 As one of these investigators (Moulton) puts it,

What became of the accumulated purchasing power that was not absorbed by higher prices? Much of it was used as time passed in buying additional quantities of consumer goods as they became available in the market. Some of it was used for the construction and improvement of homes. Some of it went for the purchase of urban or farm real estate. Some of it went to liquidate mortgages, to buy insurance policies, to increase savings deposits, and to purchase securities in the market.121

The present analysis shows that most of these transactions do not absorb any of the “accumulated purchasing power.” This excess money purchasing power cannot be used for “buying additional quantities of consumer goods” because the production of those goods creates all of the purchasing power that is needed for their purchase at the existing market price level. They cannot be used “for the construction and improvement of homes” for the same reason. These home improvements are merely consumer goods of another sort. They cannot be used for “the purchase of urban or farm real estate” or to “purchase securities in the market,” as such purchases are transactions at the same economic location. The amount of purchasing power available for consumer use is not altered by such transactions, regardless of the prices at which the sales are made.

”Purchase of insurance policies” is equivalent to consumption, except to the extent that the equities of the policyholders or stockholders are increased.

Money purchasing power can be withdrawn from the stream going to the markets by storing the money or by retiring currency (or its equivalent), but unless it is thus withdrawn the entire amount is used for the purchase of goods currently put on the market by producers. (Thus far in these discussions, only the interactions in a self-contained unit are being considered. Foreign trade, to be considered later, may cause some modification of the market situation, but these changes are separate and distinct from the phenomena with which we are now concerned, and can be added later.)

”Bidding up prices” of securities and real estate is often cited as one of the ways in which excess money purchasing power is absorbed during the boom phase of the business cycle, particularly by those who deplore the diversion of funds from more productive uses. But this is another misconception. As noted earlier in the present chapter, these speculative price increases finance themselves. The amount of money purchasing power available for consumer use is not altered in any respect by these transactions, regardless of the prices at which the sales were made. However, the revaluation of assets generates further credit transactions that do affect the money reservoirs.

The use of credit is normally limited by the amount of acceptable security available to the prospective borrowers. Under present banking policies, when market prices rise a larger amount of credit will be extended on the same security. The purely imaginary additional values resulting from speculative transactions thus have the effect of temporarily enlarging the credit reservoir. Consequently, they increase the active money purchasing power, rather than absorbing it. During periods of increasing business activity there is also more than the usual amount of creation of claims against the future: patents, monopoly privileges, etc. Money purchasing power obtained by means of credit based on the present value of such claims helps extend the economic unbalance.

In addition to the money reservoirs there are also reservoirs of goods. Those goods in the hands of consumers can be ignored for present purposes, as they have no effect on the general economic situation regardless of what disposition is made of them (Principle XIII). Goods in producers’ stocks do play a part in the market process. There is always a certain quantity of finished and partly finished goods in the possession of the producers, or in transit, but during those periods when prices are rising and buyers are plentiful, the stocks of goods drop because of the unbalanced pressure on the buying side. This additional volume of goods flowing to the markets from storage contributes to some degree toward holding prices down, and consequently it is a stabilizing factor during the rising phase of the cycle, but unfortunately only a minor one, from the overall standpoint.

The producers may also have reserves in the form of capital assets that are readily marketable, but neither the accumulation nor the utilization of such reserves influences the price structure or the business cycle in any way. These capital assets must be bought in order to accumulate them, and sold in order to utilize their purchasing power. In the purchase and sale the markets are affected to the same extent as if the money had been paid out in dividends and the purchasing power had been used by the individual recipients.

When business is good, the opportunities for profitable use of money are relatively plentiful, and the reasons for holding it in reserve are minimized. As a consequence, money flows out of storage during the business upswings. Under the influence of the augmented money stream, market prices rise still more, and this in turn adds to the psychological forces inducing further withdrawals from the reservoirs. Here, then, is the first of the explanations that Reynolds called for in the statement quoted earlier. In its early stages the business boom is a self-reinforcing process.

But the withdrawals from the reservoirs cannot continue indefinitely, because there are finite limits in each case (which is the reason for using the term “reservoir” in application to the various sources of inflationary additions to the money purchasing power stream). Obviously money cannot be withdrawn from storage in excess of the amounts stored, and when the money reservoir nears the empty point the outward flow must necessarily diminish. Similarly, credit cannot continue to increase without limit. As time goes on it becomes more and more difficult to find additional security acceptable to the lender. Even governments do not have unlimited credit.

There is a normal level of each reservoir, determined by the amount of borrowing that would be done, and the amount of money that would be kept in reserve, if business activity were riding along without any apparent trend one way or the other. The rising prices and increasing profits in the case now being analyzed cause the growth of a spirit of optimism regarding future prospects, and induce withdrawals which lower the levels in the reservoirs below normal. But these lower levels can only be maintained by the constant application of an external force-the optimistic public attitude-and it can therefore be said that a condition of strain has been produced in the reservoirs which will tend to bring the levels back to normal whenever the external forces are no longer operative. The stronger the forces operating to drain the reservoirs, the lower the levels that will eventually be reached, and the greater the strain that will be effective toward restoring normal conditions when the external forces are removed.

Just how far the rise will go before reaching its peak depends on a number of factors. One of the most important of these is the size of the reservoirs, which depends on the productive capacity of the nation. Countries that live close to the margin or starvation do not have business depressions. They have famines, wars, pestilences, and the numerous other collective ills to which the human race is subject, but not depressions. At the other extreme the United States, the land of greatest physical wealth, has the worst booms and depressions, just as would be expected from the theoretical principles that have been developed. The larger the reservoirs, the more they can affect our economic life if they are not properly controlled. A beaver dam may break without any serious consequences, but an uncontrolled release from a larger reservoir may result in a catastrophe.

We have every reason to believe that the continued increase in technological knowledge will result in a constantly increasing production of wealth as time goes on, and unless adequate control measures are taken in time there is little doubt but that the 1929 debacle will ultimately be repeated on an even greater scale. Such controls are readily available, however, and it is to be hoped that before the next upheaval of this kind is due economic thinking can be clarified to the point where the requirements for control of the cycle will be recognized, and the necessary actions will be taken. One of the primary objectives of the present work is to contribute to such a result.

Another factor in determining the magnitude of the cyclical swing is whether or not the boom is capped by a speculative orgy. All periods of rising prices are favorable settings for excessive speculation, but the situation is much the same as that which exists in the Western forests in the early fall. Toward the end of the the dry season every forest is a potential tinder box, and serious fires can be expected periodically. Nevertheless, the forests do not all burn every year, because in addition to the favorable burning conditions there must also be a spark that strikes a vulnerable spot and sets off the conflagration. Similarly, in the case of a business boom, the potentiality of a runaway condition exists near the top of every upswing, but only occasionally is it converted into reality by a strong enough impetus.

Before turning to a consideration of the downswing, it is desirable to call attention of an important transition point on the upward curve. This is the point at which maximum employment is reached. Under present conditions, where no effective policy for maintaining full employment is being pursued, this is not a situation in which every person is working to the limit of his capacity, but the highest level of employment that can normally be reached under the prevailing economic policies. This maximum is affected by a number of factors, but it is fairly definite. As brought out in Chapter 11, any increase in the flow of money purchasing power to the producer has an effect on both production volume and price until maximum employment has been attained, after which any further increase is absorbed entirely in higher prices.

If the business boom has been moderate, and has not passed into the highly unstable speculative stage, the withdrawals from the reservoirs slack off gradually as the increased internal resistance in those reservoirs begins to overcome the upward momentum of the cycle. Since part of the artificial business prosperity is due to the unbalance between production price and market price that results from the reservoir withdrawals, any decrease in the rate of withdrawals makes further business expansion less attractive even while the trend of the cycle is still upward. Expansion is also discouraged when the normal labor supply is exhausted and labor can only be attracted to new ventures by outbidding existing enterprises. The first indication of a coming change is therefore a slowing down of the demand for new capital for business expansion purposes. It is this timing that has led some observers to suggest that the development of conditions unfavorable to new business financing is the cause of the downturn. Actually, however, this is merely one link in the chain of events stemming from the originating cause, rather than a causal factor in itself. The real cause of the reversals of the cycle can be found in the finite limits of the money and credit reservoirs and the increased resistance to withdrawals as the reservoir levels approach these limits.

A substantial amount of borrowing during the upswing is done merely for the purpose of taking advantage of rising prices. As soon as the rate of price increase slows down the possible gains of this kind diminish, and the demand for credit decreases. Some borrowers begin to liquidate their debts. The effect of the decreased borrowing is cumulative, as it still further reduces business gains and money-making opportunities, thus leading to a further drop in borrowing and further repayment of debts. These changes decrease the outward flow from the money reservoirs, and in time the net balance of the reservoir transactions becomes inward rather than outward. Market prices then fall relative to production price, and a recession is on the way. The absolute price level may not fall immediately, because of coincident wage increases, but it is a decrease in the relative price level that causes the decline to begin.

There is no stable condition at the top of the cycle. The rise has been possible only because of external forces (the urge to profit from the price increase, etc.) acting against the internal resistance of the reservoirs, and as soon as the external forces weaken, the downswing starts under the influence of the ever-present internal stresses. A bouncing ball is a good analogy. The ball cannot remain at the top of its cycle. When the initial upward momentum is overcome, and the ball stops rising, it immediately starts downward because of the ever-present pull of gravity.

There have been many expressions of puzzlement as to why it is not possible to maintain the gains that are made during a boom; why economic disasters such as that of 1929 should strike when general conditions appear to be unusually favorable. For instance, Mitchell makes this comment: “The more vividly this cumulative growth of prosperity is appreciated, the more difficult becomes the problem why prosperity does not continue indefinitely instead of being but one passing phase of business cycles.”122 Reynolds’ second question, “Why doesn't expansion continue indefinitely?” expresses the same thought. The answer is clear from our analysis. The boom prosperity is due to the withdrawals from the money reservoirs, and it cannot continue indefinitely because those reservoirs have finite limits. As soon as the withdrawals start the inevitable decrease, the business decline begins.

In case there has been a speculative excess which has superimposed an additional price rise on top of the normal cycle, the downward trend is likely to be initiated with the force of an explosion. Here there is a pyramid of fictitious values supported by nothing but the hope and belief that prices will rise still higher. If this belief receives even a mild shock it expires, and the whole speculative edifice collapses. In spite of the spectacular character of these sudden deflations, however, they are not essentially different from the milder recessions, other than in degree. The causes of the disaster are implicit in the upswing; what goes up must come down. Furthermore, the greater the rise, the greater the subsequent fall. The decline must continue (in the absence of effective countermeasures) until the reservoirs are refilled sufficiently to generate a resistance to further decline. The more nearly they are emptied during the boom, the more will have to be diverted from the current money purchasing power stream to refill them to this resistance point.

The most serious aspect of the business decline arises from the “ratchet action” mentioned by
J. M. Clark in the passage quoted in Chapter 11. During the upswing both production volume and price increase, but in the decline there is relatively little drop in price because the determining factor, the wage level, is quite inflexible in the modern economy. Production volume therefore bears the brunt of the recession. If the reverse were true-that is, if the producers could cut wages rather than volume-the business cycle would have little effect on the ordinary citizen, since changes in production price are promptly reflected in market price, and as a consequence the ability of the average consumer to purchase goods is not impaired by the wage cuts. But a reduction in employment and in the volume of goods produced strikes directly at the well-being of the entire community.

Here is one of the ironies of economic life. It is the success that the workers have achieved in their efforts to protect their wage and salary scales that is primarily responsible for the loss of jobs and the reduction of hours of work during business recessions. When the producer’s income drops, either price or volume must come down, and under present conditions it is difficult to reduce wage rates. The increased rigidity of the wage structure is one of the principal reasons for the growing seriousness of the unemployment problem, and the various measures that could be used to counteract the effect of the wage rigidity have therefore been given extensive consideration in The Road to Full Employment. As brought out in that work, when the cause of unemployment is understood it can be seen that there are ways of restoring the needed flexibility to the production price structure without returning to the unpopular and rather inequitable practice of giving the employers full control over wage rates.

After the decline starts, the downward movement of the cycle is accelerated by a reversal of the influences that aided the upswing. As prices fall the opportunities for profitable use of credit decrease, and at the same time lenders become more hesitant about extending credit, as well as less able to do so because of the reduced liquidity of their own assets. The decline in business opportunities and the apprehension about the future combine to encourage storage of money. The fall in the general price level reduces the market value of capital assets, and thus contributes powerfully to the contraction in credit. Miscellaneous claims against the future find less ready acceptance.

Most of the influences that resisted the upward tendency reverse themselves and resist the downswing. Producers increase their storage of goods, reducing the flow to the markets. (This is usually involuntary, as it results from inability to sell the full output, rather than from a deliberate policy of increasing inventories, but the economic effect is the same regardless of the reasons for the action). Government borrowing is usually increased. Those producers who are fortunate enough to have reserves of cash or other liquid assets are able to draw upon them as the incoming stream of money purchasing power diminishes. As brought out in Chapter 11, the stockholders who own all of the fixed assets of a corporation also own the corporate reserves. But while the fixed assets and that portion of the earnings of the enterprise that has been paid out in dividends are not available for meeting current production expenses, any portion of the earnings that has been retained in the form of liquid reserves can be used for this purpose if necessary. Such reserves which are subject to the control of the officers of the corporation therefore have the status of producer purchasing power reservoirs rather than consumer reservoirs, even though the ownership rests in the individual stockholders.

As the filling of the reservoirs proceeds, and the reservoir levels rise above normal levels, a resistance to further input develops in the same way that the resistance to withdrawals increased during the upswing. Again the reservoirs have limits. Repayment of debts can continue only until the outstanding obligations have been met. Then the payments cease. Storage of money does not have quite as definite an upper limit, but money storage carries a penalty, loss of earning power, and as the losses from this source increase, the resistance to further storage becomes greater. As in the upswing, therefore, the momentum of the decline is finally reversed by the increased reservoir resistance, and the downward movement stops. Here, again, the situation is highly unstable. The existing reservoir levels are so far from normal that they can be maintained only by a strong external force, a fear of the future generated by falling prices and declining employment. As the decline tapers off and finally ends, this force weakens, the cost of money storage is harder to justify, and withdrawals from the reservoirs begin. Prices and employment then start to rise, reversing the psychological outlook, and a new cycle begins.

When the recession is relatively mild, the recovery from the low point takes place automatically in much the same manner as the decline from the peak. But if it degenerates into a major depression, the problem of getting started on the upward path is more complicated. As noted in Chapter 11, after business has slipped past a certain point any additional producer income that might develop goes almost entirely to bringing profits back to a tolerable level, and does not increase production volume. Without an increase in production and employment the needed change to a spirit of public optimism is not easily achieved. Furthermore, under such conditions a strong pressure is exerted on the government to do something. Anything is better than nothing, says the voting public. Unfortunately, something is not necessarily better than nothing. It is often a great deal worse than nothing, Indeed, the majority of the measures that are resorted to under the stress of an emergency where the government is desperate for a remedy of some kind definitely delay or discourage the beginning of a real upswing. If they are justified at all, it is only on the assumption that they head off some still more drastic and destructive action on the part of a dissatisfied populace.

There is still another reason why the upturn is not always symmetrical with the downturn, particularly when the depression is severe. This is the fact that it takes a positive decision to spend, whereas not spending is merely negative and requires no specific decision. At the top of the cycle indecision is equivalent to a decision against further spending, and has the same effect toward reversing the cycle. The downswing is therefore certain to begin as soon as the upswing levels off; there is no period of hesitation. At the bottom, however, a positive decision is required to initiate the spending that will operate toward reversal of the cycle, and indecision defers the rise. This explains why governmental measures that destroy confidence can prevent or delay an upturn, although government efforts to maintain optimism are powerless to arrest the start of a decline when business is at the top of the cycle. The pessimism in the depression is not necessarily stronger than the optimism in the boom, but it is more effective because it has powerful allies in uncertainty and indecision.

It is evident from the foregoing description of the mechanism of the business cycle that those who are so optimistic regarding the ability of the government to prevent a repetition of the 1930 depression are indulging in wishful thinking. They are not even watching the right horse. They are failing to recognize that a depression is a price phenomenon, and that, however important other features of the downward stages of the business cycle may be, the fall of the price level is the essence of the depression. The “deficit spending” policy, on which so much reliance is being placed, will no more be able to cope with a new depression of a major character than it was to meet the situation in the 1930s, when it was pursued with fully as much vigor and enthusiasm as can be expected in the future.

There seems to be a general tendency to forget that deficit spending and the “built-in stabilizers” such as social security, are not something new that the economists have pulled out of the hat since the Great Depression. The spending programs were carried out on a massive scale during that depression, with totally unsatisfactory results. Unquestionably, this kind of a program exerts some influence in the right direction. But, as an analysis of the nature of this contribution that will be carried out in a later chapter will show, it puts a heavy burden on business and the taxpayers just at the time they are least able to stand anything extra, and it therefore prevents or delays the restoration of public confidence in the economic situation which is essential for a real recovery.

Furthermore, such a program is not powerful enough to meet a major emergency, as there is a limit to the load that the taxpayers can, or will, support, a limit that is none the less real when the government tries to hide it by financial juggling. As the number of persons on government jobs or government support becomes greater, and the number of persons that foot the bill becomes smaller, this limit emerges as a painful reality, and the program bogs down just when it is needed most. The direct connection between the magnitude of the national wealth and the violence of economic fluctuations that was pointed out in an earlier paragraph means that even more powerful anti-depression measures will be needed in the future, if the economy remains uncontrolled. As wealth increases, the amplitude of the cyclical fluctuations also increases; that is, depressions become worse. Unless we adopt a program which will actually control the flow of money purchasing power to prevent the cyclical fluctuations-some program that is not, like the deficit spending policy, a burden on the taxpayers and hence subject to collapse at the very time when it is most urgently needed-we can look forward to even worse situations than that which was experienced in the thirties.

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