America's Great Depression (7 page)

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America’s Great Depression

We may, therefore, expect
specific
business fluctuations all the time. There is no need for any special “cycle theory” to account for them. They are simply the results of changes in economic data and are fully explained by economic theory. Many economists, however, attribute general business depression to “weaknesses” caused by a “depression in building” or a “farm depression.” But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a
general
business depression—a phenomenon of the true “business cycle.” Suppose, for example, that a shift in consumer tastes, and technologies, causes a shift in demand from farm products to
other
goods. It is pointless to say, as many people do, that a farm depression will ignite a general depression, because farmers will buy less goods, the people in industries selling to farmers will buy less, etc. This ignores the fact that people producing the
other
goods now favored by consumers will prosper;
their
demands will increase.

The problem of the business cycle is one of general boom and depression; it is not a problem of exploring specific industries and wondering what factors make each one of them relatively prosperous or depressed. Some economists—such as Warren and Pearson or Dewey and Dakin—have believed that there are no such things as general business fluctuations—that general movements are but the results of different cycles that take place, at different specific time-lengths, in the various economic activities. To the extent that such varying cycles (such as the 20-year “building cycle” or the seven-year locust cycle) may exist, however, they are irrelevant to a study of business cycles in
general
or to business depressions in particular. What we are trying to explain are
general
booms and busts in business.

In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange—money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if
all
prices move up or down together, some change must have occurred in the
monetary
sphere. Only
The Positive Theory of the Cycle

7

changes in the demand for, and/or the supply of, money will cause general price changes. An increase in the supply of money, the demand for money remaining the same, will cause a fall in the purchasing power of each dollar, i.e., a general rise in prices; conversely, a drop in the money supply will cause a general decline in prices. On the other hand, an increase in the general demand for money, the supply remaining given, will bring about a rise in the purchasing power of the dollar (a general fall in prices); while a fall in demand will lead to a general rise in prices. Changes in prices in general, then, are determined by changes in the supply of and demand for money. The supply of money consists of the stock of money existing in the society. The demand for money is, in the final analysis, the willingness of people to hold cash balances, and this can be expressed as eagerness to acquire money in exchange, and as eagerness to retain money in cash balance. The supply of goods in the economy is one component in the social demand for money; an increased supply of goods will,
other things being equal
, increase the demand for money and therefore tend to lower prices.

Demand for money will tend to be lower when the purchasing power of the money-unit is higher, for then each dollar is more effective in cash balance. Conversely, a lower purchasing power (higher prices) means that each dollar is less effective, and more dollars will be needed to carry on the same work.

The purchasing power of the dollar, then, will remain constant when the stock of, and demand for, money are in equilibrium with each other: i.e., when people are willing to hold in their cash balances the exact amount of money in existence. If the demand for money exceeds the stock, the purchasing power of money will rise until the demand is no longer excessive and the market is cleared; conversely, a demand lower than supply will lower the purchasing power of the dollar, i.e., raise prices.

Yet, fluctuations in general business, in the “money relation,” do not by themselves provide the clue to the mysterious business cycle. It is true that any cycle in general business must be transmitted through this money relation: the relation between the stock of, and the demand for, money. But these changes in themselves explain little. If the money supply increases or demand falls, for
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America’s Great Depression

example, prices will rise; but why should this generate a “business cycle”? Specifically, why should it bring about a depression? The early business cycle theorists were correct in focusing their attention on the
crisis
and
depression
: for these are the phases that puzzle and shock economists and laymen alike, and these are the phases that most need to be explained.

THE PROBLEM: THE CLUSTER OF ERROR

The explanation of depressions, then, will not be found by referring to specific or even general business fluctuations
per se
.

The main problem that a theory of depression must explain is:
why
is there a sudden general cluster of business errors?
This is the first question for any cycle theory. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting.

A general review of entrepreneurship is now in order. Entrepreneurs are largely in the business of forecasting. They must invest and pay costs in the present, in the expectation of recouping a profit by sale either to consumers or to other entrepreneurs further down in the economy’s structure of production. The better entrepreneurs, with better judgment in forecasting consumer or other producer demands, make profits; the inefficient entrepreneurs suffer losses. The market, therefore, provides a training ground for the reward and expansion of successful, far-sighted entrepreneurs and the weeding out of inefficient businessmen. As a rule only some businessmen suffer losses at any one time; the bulk either break even or earn profits. How, then, do we explain the curious phenomenon of the crisis when almost all entrepreneurs suffer sudden losses? In short, how did all the country’s astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory.

It is not legitimate to reply that sudden changes in the data are responsible. It is, after all, the business of entrepreneurs to forecast
The Positive Theory of the Cycle

9

future changes, some of which are sudden. Why did their forecasts fail so abysmally?

Another common feature of the business cycle also calls for an explanation. It is the well-known fact that
capital-goods industries
fluctuate more widely than do the consumer-goods industries.
The capital-goods industries—especially the industries supplying raw materials, construction, and equipment to other industries—expand much further in the boom, and are hit far more severely in the depression.

A third feature of every boom that needs explaining is the increase in the quantity of money in the economy. Conversely, there is generally, though not universally, a fall in the money supply during the depression.

THE EXPLANATION: BOOM AND DEPRESSION

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time.4 The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people’s
time preferences
—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference 4Siegfried Budge,
Grundzüge der Theoretische Nationalökonomie
(Jena, 1925), quoted in Simon S. Kuznets, “Monetary Business Cycle Theory in Germany,”
Journal of Political Economy
(April, 1930): 127–28.

Under conditions of free competition . . . the market is . . . dependent upon supply and demand . . . there could [not] develop a disproportionality in the production of goods, which could draw in the whole economic system . . . such a disproportionality can arise only when, at some decisive point, the price structure does not base itself upon the play of only free competition, so that some arbitrary influence becomes possible.

Kuznets himself criticizes the Austrian theory from his empiricist, anti-cause and effect-standpoint, and also erroneously considers this theory to be “static.”
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America’s Great Depression

rate be, and the lower therefore will be the
pure interest rate
, which is determined by the time preferences of the individuals in society.

A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components.

Varying degrees of entrepreneurial risk bring about a
structure
of interest rates instead of a single uniform one, and purchasing-power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.5

Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business?6 The new money pours forth on the loan market and lowers the loan rate of interest. It
looks as if
the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in “longer processes of production,” i.e., the capital structure is lengthened, especially in the “higher orders” most remote from the consumer.

5This is the “pure time preference theory” of the rate of interest; it can be found in Ludwig von Mises,
Human Action
(New Haven, Conn.: Yale University Press, 1949); in Frank A. Fetter,
Economic Principles
(New York: Century, 1915), and idem
,
“Interest Theories Old and New,
” American Economic Review
(March, 1914): 68–92.

6“Banks,” for many purposes, include also savings and loan associations, and life insurance companies, both of which create new money via credit expansion to business. See below for further discussion of the money and banking question.

The Positive Theory of the Cycle

11

Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer)—from consumer goods to capital goods industries.7

If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained.

But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the
old
consumption–investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

A favorite explanation of the crisis is that it stems from “underconsumption”—from a failure of consumer demand for goods at prices that could be profitable. But this runs contrary to the commonly known fact that it is
capital goods
, and not consumer goods, industries that really suffer in a depression. The failure is one of
entrepreneurial demand
for the higher order goods, and this in turn is caused by the shift of demand back to the old proportions.

In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass 7On the structure of production, and its relation to investment and bank credit, see F.A. Hayek,
Prices and Production
(2nd ed., London: Routledge and Kegan Paul, 1935); Mises,
Human Action;
and Eugen von Böhm-Bawerk, “Positive Theory of Capital,” in
Capital and Interest
(South Holland, Ill.: Libertarian Press, 1959), vol. 2.