Notes on the Trade Cycle

The preceding analysis may appear to be in conformity with the view of those who hold

Some people think that:

• over-investment is the characteristic of the boom
• the avoidance of this over-investment is the only possible remedy for the ensuing slump
• the slump cannot be prevented by a low interest rate
• the boom can be avoided by a high interest rate.

There is force in the argument that a high interest rate is much more effective against a boom than a low interest rate is against a slump.

To infer these conclusions from the above would, however, misinterpret my analysis and lead to error.

“Over-investment” is ambiguous.

• It may refer to investments which are destined to disappoint the expectations which prompted them or for which there is no use in conditions of severe unemployment, or it may indicate a state of affairs where every kind of capital-goods is so abundant that there is no new investment which is expected, even in conditions of full employment, to earn in the course of its life more than its replacement cost.

It is only the latter state of affairs which is one of over-investment, strictly speaking, in the sense that any further investment would be a sheer waste of resources.[4]

Moreover, even if over-investment in this sense was a normal characteristic of the boom, the remedy would not lie in clapping on a high rate of interest which would probably deter some useful investments and might further diminish the propensity to consume, but in taking drastic steps, by redistributing incomes or otherwise, to stimulate the propensity to consume.

According to my analysis, however, it is only in the former sense that the boom can be said to be characterised by over-investment. The situation, which I am indicating as typical, is not one in which capital is so abundant that the community as a whole has no reasonable use for any more, but where investment is being made in conditions which are unstable and cannot endure, because it is prompted by expectations which are destined to disappointment. It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment.

But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2% in conditions of full employment are made in the expectation of a yield of, say, 6% and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2% in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2% in conditions of full employment, in fact yield less than nothing.

We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are. Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest![5] For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom. The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive. Except during the war, I doubt if we have any recent experience of a boom so strong that it led to full employment.

In the United States employment was very satisfactory in 1928-29 on normal standards; but I have seen no evidence of a shortage of labour, except, perhaps, in the case of a few groups of highly specialised workers. Some “bottle-necks” were reached, but output as a whole was still capable of further expansion. Nor was there over-investment in the sense that the standard and equipment of housing was so high that everyone, assuming full employment, had all he wanted at a rate which would no more than cover the replacement cost, without any allowance for interest, over the life of the house; and that transport, public services and agricultural improvement had been carried to a point where further additions could not reasonably be expected to yield even their replacement cost. Quite the contrary. It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. The true state of affairs was of a different character. New investment during the previous five years had been, indeed, on so enormous a scale in the aggregate that the prospective yield of further additions was, coolly considered, falling rapidly.

Correct foresight would have brought down the marginal efficiency of capital to an unprecedentedly low figure; so that the “boom” could not have continued on a sound basis except with a very low long-term rate of interest, and an avoidance of misdirected investment in the particular directions which were in danger of being over-exploited. In fact, the rate of interest was high enough to deter new investment except in those particular directions which were under the influence of speculative excitement and, therefore, in special danger of being over-exploited; and a rate of interest, high enough to overcome the speculative excitement, would have checked, at the same time, every kind of reasonable new investment. Thus an increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient. It is, indeed, very possible that the prolongation of approximately full employment over a period of years would be associated in countries so wealthy as Great Britain or the United States with a volume of new investment, assuming the existing propensity to consume, so great that it would eventually lead to a state of full investment in the sense that an aggregate gross yield in excess of replacement cost could no longer be expected on a reasonable calculation from a further increment of durable goods of any type whatever. Moreover, this situation might be reached comparatively soon — say within twenty-five years or less.

I must not be taken to deny this, because I assert that a state of full investment in the strict sense has never yet occurred, not even momentarily. Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it.

IV

It may be convenient at this point to say a word about the important schools of thought which maintain, from various points of view, that the chronic tendency of contemporary societies to under-employment is to be traced to under-consumption; — that is to say, to social practices and to a distribution of wealth which result in a propensity to consume which is unduly low. In existing conditions — or, at least, in the conditions which existed until lately — where the volume of investment is unplanned and uncontrolled, subject to the vagaries of the marginal efficiency of capital as determined by the private judgment of individuals ignorant or speculative, and to a long-term rate of interest which seldom or never falls below a conventional level, these schools of thought are, as guides to practical policy, undoubtedly in the right. For in such conditions there is no other means of raising the average level of employment to a more satisfactory level. If it is impracticable materially to increase investment, obviously there is no means of securing a higher level of employment except by increasing consumption.

Practically, I only differ from these schools of thought in thinking that they may lay a little too much emphasis on increased consumption at a time when there is still much social advantage to be obtained from increased investment. Theoretically, however, they are open to the criticism of neglecting the fact that there are two ways to expand output. Even if we were to decide that it would be better to increase capital more slowly and to concentrate effort on increasing consumption, we must decide this with open eyes, after well considering the alternative. I am myself impressed by the great social advantages of increasing the stock of capital until it ceases to be scarce. But this is a practical judgment, not a theoretical imperative.

The wisest course is to advance on both fronts at once.

Whilst aiming at a socially controlled rate of investment with a view to a progressive decline in the marginal efficiency of capital, all policies for increasing the propensity to consume should be supported.

For it is unlikely that full employment can be maintained, whatever we may do about investment, with the existing propensity to consume. There is room, therefore, for both policies to operate together; — to promote investment and, at the same time, to promote consumption, not merely to the level which with the existing propensity to consume would correspond to the increased investment, but to a higher level still.

If — to take round figures for the purpose of illustration — the average level of output of to-day is 15 per cent. below what it would be with continuous full employment, and if 10 per cent. of this output represents net investment and go per cent. of it consumption — if, furthermore, net investment would have to rise 50% in order to secure full employment with the existing propensity to consume, so that with full employment output would rise from 100 to 115, consumption from go to 100 and net investment from 10 to 15= — then we might aim, perhaps, at so modifying the propensity to consume that with full employment consumption would rise from go to 103 and net investment from 10 to 12. V Another school of thought finds the solution of the trade cycle, not in increasing either consumption or investment, but in diminishing the supply of labour seeking employment; i.e. by redistributing the existing volume of employment without increasing employment or output.

This is a premature policy — much more clearly so than the plan of increasing consumption. A point comes where every individual weighs the advantages of increased leisure against increased income.

But at present the evidence is strong that most people prefer increased income to increased leisure.

I see no sufficient reason for compelling those who would prefer more income to enjoy more leisure.

It is extraordinary that a school of thought would solve the trade cycle by checking the boom in its early stages by a higher rate of interest.

Mr. D. H. Robertson defends this by saying that:

• full employment is an impracticable ideal
• the best that we can hope for is a level of employment much more stable than at present and averaging, perhaps, a little higher.

If we rule out major changes of policy affecting either the control of investment or the propensity to consume, and assume, broadly speaking, a continuance of the existing state of affairs, it is, I think, arguable that a more advantageous average state of expectation might result from a banking policy which always nipped in the bud an incipient boom by a rate of interest high enough to deter even the most misguided optimists.

The disappointment of expectation, characteristic of the slump, may lead to so much loss and waste that the average level of useful investment might be higher if a deterrent is applied.

It is difficult to be sure whether or not this is correct on its own assumptions; it is a matter for practical judgment where detailed evidence is wanting. It may be that it overlooks the social advantage which accrues from the increased consumption which attends even on investment which proves to have been totally misdirected, so that even such investment may be more beneficial than no investment at all.

Nevertheless, the most enlightened monetary control might find itself in difficulties, faced with a boom of the 1929 type in America, and armed with no other weapons than those possessed at that time by the Federal Reserve System; and none of the alternatives within its power might make much difference to the result. However this may be, such an outlook seems to me to be dangerously and unnecessarily defeatist.

It recommends for permanent acceptance too much that is defective in our existing economic scheme.

The austere view, which would employ a high rate of interest to check at once any tendency in the level of employment to rise appreciably above the average of, say, the previous decade, is, however, more usually supported by arguments which have no foundation at all apart from confusion of mind.

It flows, in some cases, from the belief that in a boom investment tends to outrun saving, and that a higher rate of interest will restore equilibrium by checking investment on the one hand and stimulating savings on the other.

This implies that saving and investment can be unequal, and has, therefore, no meaning until these terms have been defined in some special sense. Or it is sometimes suggested that the increased saving which accompanies increased investment is undesirable and unjust because it is, as a rule, also associated with rising prices. But if this were so, any upward change in the existing level of output and employment is to be deprecated.

For the rise in prices is not essentially due to the increase in investment; — it is due to the fact that in the short period supply price usually increases with increasing output, on account either of the physical fact of diminishing return or of the tendency of the cost-unit to rise in terms of money when output increases. If the conditions were those of constant supply-price, there would, of course, be no rise of prices; yet, all the same, increased saving would accompany increased investment.

It is the increased output which produces the increased saving; and the rise of prices is, merely a by-product of the increased output, which will occur equally if there is no increased saving but, instead, an increased propensity to consume. No one has a legitimate vested interest in being able to buy at prices which are only low because output is low. Or, again, the evil is supposed to creep in if the increased investment has been promoted by a fall in the rate of interest engineered by an increase in the quantity of money.

Yet there is no special virtue in the pre-existing rate of interest, and the new money is not “forced” on anyone; — it is created in order to satisfy the increased liquidity-preference which corresponds to the lower rate of interest or the increased volume of transactions, and it is held by those individuals who prefer to hold money rather than to lend it at the lower rate of interest. Or, once more, it is suggested that a boom is characterised by “capital consumption”, which presumably means negative net investment, i.e. by an excessive propensity to consume.

Unless the phenomena of the trade cycle have been confused with those of a flight from the currency such as occurred during the post-war European currency collapses, the evidence is wholly to the contrary. Moreover, even if it were so, a reduction in the rate of interest would be a more plausible remedy than a rise in the rate of interest for conditions of under-investment.

I can make no sense at all of these schools of thought; except, perhaps, by supplying a tacit assumption that aggregate output is incapable of change. But a theory which assumes constant output is obviously not very serviceable for explaining the trade cycle. VII In the earlier studies of the trade cycle, notably by Jevons, an explanation was found in agricultural fluctuations due to the seasons, rather than in the phenomena of industry. In the light of the above theory this appears as an extremely plausible approach to the problem.

For even today fluctuation in the stocks of agricultural products as between one year and another is one of the largest individual items amongst the causes of changes in the rate of current investment; whilst at the time when Jevons wrote — and more particularly over the period to which most of his statistics applied — this factor must have far outweighed all others.

According to Jevons’s theory, the trade cycle was primarily due to the fluctuations in the bounty of the harvest.

He believed that when a large harvest is gathered, an important addition is usually made to the quantity carried over into later years.

The proceeds of this addition are added to the current incomes of the farmers and are treated by them as income; whereas the increased carry-over involves no drain on the income-expenditure of other sections of the community but is financed out of savings.

The addition to the carry-over is an addition to current investment. This conclusion is not invalidated even if prices fall sharply. Similarly when there is a poor harvest, the carry-over is drawn upon for current consumption, so that a corresponding part of the income-expenditure of the consumers creates no current income for the farmers. That is to say, what is taken from the carry-over involves a corresponding reduction in current investment.

Thus, if investment in other directions is taken to be constant, the difference in aggregate investment between a year in which there is a substantial addition to the carry-over and a year in which there is a substantial subtraction from it may be large; and in a community where agriculture is the predominant industry it will be overwhelmingly large compared with any other usual cause of investment fluctuations.

Thus it is natural that we should find the upward turning-point to be marked by bountiful harvests and the downward turning-point by deficient harvests. The further theory, that there are physical causes for a regular cycle of good and bad harvests, is, of course, a different matter with which we are not concerned here.

More recently, the theory has been advanced that it is bad harvests, not good harvests, which are good for trade, either because bad harvests make the population ready to work for a smaller real reward or because the resulting redistribution of purchasing-power is held to be favourable to consumption. Needless to say, it is not these theories which I have in mind in the above description of harvest phenomena as an explanation of the trade cycle.

The agricultural causes of fluctuation are, however, much less important in the modern world for two reasons. In the first place agricultural output is a much smaller proportion of total output.

in the second place the development of a world market for most agricultural products, drawing upon both hemispheres, leads to an averaging out of the effects of good and bad seasons, the percentage fluctuation in the amount of the world harvest being far less than the percentage fluctuations in the harvests of individual countries.

But in old days, when a country was mainly dependent on its own harvest, it is difficult to see any possible cause of fluctuations in investment, except war, which was in any way comparable in magnitude with changes in the carry-over of agricultural products. Even to-day it is important to pay close attention to the part played by changes in the stocks of raw materials, both agricultural and mineral, in the determination of the rate of current investment.

The slow recovery from a slump, after the turning-point has been reached, is mainly due to the deflationary effect of the reduction of redundant stocks to a normal level.

At first the accumulation of stocks, which occurs after the boom has broken, moderates the rate of the collapse; but we have to pay for this relief later on in the damping-down of the subsequent rate of recovery. Sometimes, the reduction of stocks may have to be virtually completed before any measurable degree of recovery can be detected.

For a rate of investment in other directions, which is sufficient to produce an upward movement when there is no current disinvestment in stocks to set off against it, may be quite inadequate so long as such disinvestment is still proceeding. We have seen, I think, a signal example of this in the earlier phases of America’s “New Deal”.

When President Roosevelt’s substantial loan expenditure began, stocks of all kinds — and particularly of agricultural products — still stood at a very high level. The “New Deal” partly consisted in a strenuous attempt to reduce these stocks — by curtailment of current output and in all sorts of ways. The reduction of stocks to a normal level was a necessary process — a phase which had to be endured.

But so long as it lasted, namely, about two years, it constituted a substantial offset to the loan expenditure which was being incurred in other directions. Only when it had been completed was the way prepared for substantial recovery.

Recent American experience has also afforded good examples of the part played by fluctuations in the stocks of finished and unfinished goods — “inventories” as it is becoming usual to call them — in causing the minor oscillations within the main movement of the Trade Cycle.

Manufacturers, setting industry in motion to provide for a scale of consumption which is expected to prevail some months later, are apt to make minor miscalculations, generally in the direction of running a little ahead of the facts.

When they discover their mistake they have to contract for a short time to a level below that of current consumption so as to allow for the absorption of the excess inventories; and the difference of pace between running a little ahead and dropping back again has proved sufficient in its effect on the current rate of investment to display itself quite clearly against the background of the excellently complete statistics now available in the United States.

Author’s Footnotes

1. It is often convenient in contexts where there is no room for misunderstanding to write “the marginal efficiency of capital”, where “the schedule of the marginal efficiency of capital” is meant.

2. I have shown above (Chapter 12) that, although the private investor is seldom himself directly responsible for new investment, nevertheless the entrepreneurs, who are directly responsible, will find it financially advantageous, and often unavoidable, to fall in with the ideas of the market, even though they themselves are better instructed.

3. Some part of the discussion in my Treatise on Money, Book IV, bears upon the above.

4. On certain assumptions, however, as to the distribution of the propensity to consume through time, investment which yielded a negative return might be advantageous in the sense that, for the community as a whole, it would maximise satisfaction.

5. See below (p. 327) for some arguments which can be urged on the other side. For, if we are precluded from making large changes in our present methods, I should agree that to raise the rate of interest during a boom may be, in conceivable circumstances, the lesser evil.