Notes on the Trade Cycle

The preceding chapters showed what determines the volume of employment at any time.

• It follows that our theory can explain the Trade Cycle.

The Trade Cycle is highly complex.

• Every element in our analysis will be required for its complete explanation.

We shall find that fluctuations in the propensity to consume, in the state of liquidity-preference, and in the marginal efficiency of capital have all played a part.

But I suggest that the essential character of the Trade Cycle, and, especially, the regularity of time-sequence and of duration which justifies us in calling it a cycle, is mainly due to the way in which the marginal efficiency of capital fluctuates.

The Trade Cycle is a cyclical change in the marginal efficiency of capital. It is complicated and often aggravated by associated changes in the other significant short-period variables of the economic system.

Section 1

A cyclical movement means that as the system progresses in, e.g., the upward direction, the forces propelling it upwards at first gather force and have a cumulative effect on one another but gradually lose their strength until at a certain point they tend to be replaced by forces operating in the opposite direction; which in turn gather force for a time and accentuate one another, until they too, having reached their maximum development, wane and give place to their opposite.

We do not, however, merely mean by a cyclical movement that upward and downward tendencies, once started, do not persist for ever in the same direction but are ultimately reversed.

We mean also that there is some recognisable degree of regularity in the time sequence and duration of the upward and downward movements. There is, however, another characteristic of what we call the Trade Cycle which our explanation must cover if it is to be adequate; namely, the phenomenon of the crisis — the fact that the substitution of a downward for an upward tendency often takes place suddenly and violently, whereas there is, as a rule, no such sharp turning-point when an upward is substituted for a downward tendency.

Any fluctuation in investment not offset by a corresponding change in the propensity to consume will, of course, result in a fluctuation in employment. Since, therefore, the volume of investment is subject to highly complex influences, it is highly improbable that all fluctuations either in investment itself or in the marginal efficiency of capital will be of a cyclical character. One special case, in particular, namely, that which is associated with agricultural fluctuations, will be separately considered in a later section of this chapter.

I suggest, however, that there are certain definite reasons why, in the case of a typical industrial trade cycle in the nineteenth-century environment, fluctuations in the marginal efficiency of capital should have had cyclical characteristics. These reasons are by no means unfamiliar either in themselves or as explanations of the trade cycle.

My only purpose here is to link them up with the preceding theory. II I can best introduce what I have to say by beginning with the later stages of the boom and the onset of the “crisis”. We have seen above that the marginal efficiency of capital[1] depends, not only on the existing abundance or scarcity of capital-goods and the current cost of production of capital-goods, but also on current expectations as to the future yield of capital-goods.

In the case of durable assets it is, therefore, natural and reasonable that expectations of the future should play a dominant part in determining the scale on which new investment is deemed advisable. But, as we have seen, the basis for such expectations is very precarious. Being based on shifting and unreliable evidence, they are subject to sudden and violent changes. Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part.

But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital. The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also. It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.[2] Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity-preference — and hence a rise in the rate of interest.

Thus the fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse in the marginal efficiency of capital, particularly in the case of those types of capital which have been contributing most to the previous phase of heavy new investment. Liquidity-preference, except those manifestations of it which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

It is this which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority.

But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

The explanation of the time-element in the trade cycle, of the fact that an interval of time of a particular order of magnitude must usually elapse before recovery begins, is to be sought in the influences which govern the recovery of the marginal efficiency of capital.

There are reasons, given firstly by the length of life of durable assets in relation to the normal rate of growth in a given epoch, and secondly, by the carrying-costs of surplus stocks, why the duration of the downward movement should have an order of magnitude which is not fortuitous, which does not fluctuate between, say, one year this time and ten years next time, but which shows some regularity of habit between, let us say, three and five years. Let us recur to what happens at the crisis. So long as the boom was continuing, much of the new investment showed a not unsatisfactory current yield.

The disillusion comes because doubts suddenly arise concerning the reliability of the prospective yield, perhaps because the current yield shows signs of failing off, as the stock of newly produced durable goods steadily increases.

If current costs of production are thought to be higher than they will be later on, that will be a further reason for a fall in the marginal efficiency of capital. Once doubt begins it spreads rapidly. Thus at the outset of the slump there is probably much capital of which the marginal efficiency has become negligible or even negative. But the interval of time, which will have to elapse before the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency, may be a somewhat stable function of the average durability of capital in a given epoch. If the characteristics of the epoch shift, the standard time-interval will change.

If, for example, we pass from a period of increasing population into one of declining population, the characteristic phase of the cycle will be lengthened.

But we have in the above a substantial reason why the duration of the slump should have a definite relationship to the length of life of durable assets and to the normal rate of growth in a given epoch. The second stable time-factor is due to the carrying-costs of surplus stocks which force their absorption within a certain period, neither very short nor very long.

The sudden cessation of new investment after the crisis will probably lead to an accumulation of surplus stocks of unfinished goods.

The carrying-costs of these stocks will seldom be less than 10 per cent. per annum. Thus the fall in their price needs to be sufficient to bring about a restriction which provides for their absorption within a period of, say, three to five years at the outside. Now the process of absorbing the stocks represents negative investment, which is a further deterrent to employment; and, when it is over, a manifest relief will be experienced. Moreover, the reduction in working capital, which is necessarily attendant on the decline in output on the downward phase, represents a further element of disinvestment, which may be large; and, once the recession has begun, this exerts a strong cumulative influence in the downward direction.

In the earliest phase of a slump, there will probably be an investment in increasing stocks which helps to offset disinvestment in working-capital.

In the next phase, there may be a short period of disinvestment both in stocks and in working-capital.

After the lowest point has been passed, there is likely to be a further disinvestment in stocks which partially offsets reinvestment in working-capital.

Finally, after the recovery is well on its way, both factors will be simultaneously favourable to investment. It is against this background that the additional and superimposed effects of fluctuations of investment in durable goods must be examined. When a decline in this type of investment has set a cyclical fluctuation in motion there will be little encouragement to a recovery in such investment until the cycle has partly run its course.[3]

Unfortunately a serious fall in the marginal efficiency of capital also tends to affect adversely the propensity to consume. For it involves a severe decline in the market value of Stock Exchange equities. Now, on the class who take an active interest in their Stock Exchange investments, especially if they are employing, borrowed funds, this naturally exerts a very depressing influence. These people are, perhaps, even more influenced in their readiness to spend by rises and falls in the value of their investments than by the state of their income. With a “stock-minded” public, as in the United States to-day, a rising stock-market may be an almost essential condition of a satisfactory propensity to consume; and this circumstance, generally overlooked until lately, obviously serves to aggravate still further the depressing effect of a decline in the marginal efficiency of capital.

When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious. But during the downward phase, when both fixed capital and stocks of materials are for the time being redundant and working-capital is being reduced, the schedule of the marginal efficiency of capital may fall so low that it can scarcely be corrected, so as to secure a satisfactory rate of new investment, by any practicable reduction in the rate of interest. Thus with markets organised and influenced as they are at present, the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations that it cannot be sufficiently offset by corresponding fluctuations in the rate of interest. Moreover, the corresponding movements in the stock-market may, as we have seen above, depress the propensity to consume just when it is most needed. In conditions of laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.