Human Action

It has been pointed out that it would be an error to look upon credit expansion exclusively as a mode of government interference with the market. The fiduciary media did not come into existence as instruments of government policies deliberately aiming at high prices and high nominal wage rates, at lowering the market rate of interest and at debt abatement. They evolved out of the regular business of banking. When the bankers, whose receipts for call money deposited were [p. 794] dealt with by the public as money-substitutes, began to lend a part of the funds deposited with them, they had nothing else in view than their own business. They considered it harmless not to keep the whole equivalent of the receipts issued as a cash reserve in their vaults. They were confident that they would always be in a position to comply with their obligations and, without delay, redeem the notes issued even if they were to lend a part of the deposits. Banknotes became fiduciary media within the operation of the unhampered market economy. The begetter of credit expansion was the banker, not the authority.

But today credit expansion is exclusively a government practice. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. Credit expansion is the governments’ foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.

The inescapable consequences of credit expansion are shown by the theory of the trade cycle. Even those economists who still refuse to acknowledge the correctness of the monetary or circulation credit theory of the cyclical fluctuations of business have never dared to question the conclusiveness and irrefutability of what this theory asserts with regard to the necessary effects of credit expansion. These economists too must admit and do admit that the upswing is invariably conditioned by credit expansion, that it could not come into being and continue without credit expansion, and that it turns into depression when the further progress of credit expansion stops. Their explanation of the trade cycle in fact boils down to the assertion that what first generates the upswing is not credit expansion, but other factors. The credit expansion which even in their opinion is an indispensable requisite of the general boom, is, they say, not the outcome of a policy deliberately aiming at low interest rates and at encouraging additional investment for which the capital goods needed are lacking. It is something which, without active interference on the part of the authorities, in a miraculous way always appears whenever these factors begin their operation. [p. 795]

It is obvious that these economists contradict themselves in opposing plans to eliminate the fluctuations of business by abstention from credit expansion. The supporters of the naive inflationist vies of history are consistent when they infer from their--of course, utterly fallacious and contradictory--tenets that credit expansion is the economic panacea. But those who do not deny that credit expansion brings about the boom that is the indispensable condition of the depression disagree with their own doctrine in fighting the proposals to curb credit expansion. Both the spokesmen of the governments and the powerful pressure groups and the champions of the dogmatic “unorthodoxy” that dominates the university departments of economics agree that one should try to avert the recurrence of depressions and that the realization of this end requires the prevention of booms. They cannot advance tenable arguments against the proposals to abstain from policies encouraging credit expansion. But they stubbornly refuse to listen to any such idea. They passionately disparage the plans to prevent credit expansion as devices which would perpetuate depressions. Their attitude clearly demonstrates the correctness of the statement that the trade cycle is the product of policies intentionally aimed at lowering the rate of interest and engendering artificial booms.

It is a fact that today measures aimed at lowering the rate of interest are generally considered highly desirable and that credit expansion is viewed as the efficacious means for the attainment of this end. It is this prepossession that impels all governments to fight the gold standard. All political parties and all pressure groups are firmly committed to an easy money policy.5

The objective of credit expansion is to favor the interests of some groups of the population at the expense of others. This is, of course, the best that interventionism can attain when it does not hurt the interests of all groups. But while making the whole community poorer, it may still enrich some strata. Which groups belong to the latter class depends on the special data of each case.

The idea which generated what is called qualitative credit control [p. 796] is to channel the additional credit in such a way as to concentrate the alleged blessings of credit expansion upon certain groups and to withhold them from other groups. The credits should not go to the stock exchange, it is argued, and should not make stock prices soar. They should rather benefit the “legitimate productive activity” of the processing industries, of mining, of “legitimate commerce,” and, first of all, of farming. Other advocates of qualitative credit control want to prevent the additional credits from being used for investment in fixed capital and thus immobilized. They are to be used, instead, for the production of liquid goods. According to these plans the authorities give the banks concrete directions concerning the types of loans they should grant or are forbidden to grant.

However, all such schemes are vain. Discrimination in lending is no substitute for checks placed on credit expansion, the only means that could really prevent a rise in stock exchange quotations and an expansion of investment in fixed capital. The mode in which the additional amount of credit finds its way into the loan market is only of secondary importance. What matters is that there is an inflow of newly created credit. If the banks grand more credits to the farmers, the farmers are in a position to repay loans received from other sources and to pay cash for their purchases. If they grant more credits to business as circulating capital, they free funds which were previously tied up for this use. In any case they create an abundance of disposable money for which its owners try to find the most profitable investment. Very promptly these funds find outlets in the stock exchange or in fixed investment. The notion that it is possible to pursue a credit expansion without making stock prices rise and fixed investment expand is absurd.6

The typical course of events under credit expansion was until a few decades ago determined by two facts: that it was credit expansion under the gold standard, and that it was not the outcome of concerted action on the part of the various national governments and the central banks whose conduct these governments directed. The first of these facts meant that governments were not prepared to abandon the convertibility of their country’s banknotes according to the rigidly fixed parity. The second fact resulted in a lack of quantitative uniformity in the size of credit expansion. Some countries got ahead of other countries and their banks were faced with the danger of a serious external drain upon their reserves in gold and foreign exchange. In order to preserve their own solvency, these banks were forced to take recourse to drastic credit restriction. Thus they [p. 797] created the panic and inaugurated the depression on the domestic market. The panic very soon spread to other countries. Businessmen in these other countries became frightened and increased their borrowing in order to strengthen their liquid funds for all possible contingencies. It was precisely this increased demand for new credits which impelled the monetary authorities of their own countries, already alarmed by the crisis in the first country, also to resort to contraction. Thus within a few days or weeks the depression became an international phenomenon.

The policy of devaluation has to some extent altered this typical sequence of events. Menaced by an external drain, the monetary authorities do not always resort to credit restriction and to raising the rate of interest charged by the central banking system. They devalue. Yet devaluation does not solve the problem. If the government does not care how far foreign exchange rates may rise, it can for some time continue to cling to credit expansion. But one day the crack-up boom will annihilate its monetary system. On the other hand, if the authority wants to avoid the necessity of devaluing again and again at an accelerated pace, it must arrange its domestic credit policy in such a way as not to outrun in credit expansion the other countries against which it wants to keep its domestic currency at par.

Many economists take it for granted that the attempts of the authorities to expand credit will always bring about the same almost regular alternation between periods of booming trade and of subsequent depression. They assume that the effects of credit expansion will in the future not differ from those that have been observed since the end of the eighteenth century in Great Britain and since the middle of the nineteenth century in Western and Central Europe and in North America. But we may wonder whether conditions have not changed. The teachings of the monetary theory of the trade cycle are today so well known even outside of the circle of economists, that the naive optimism which inspired the entrepreneurs in the boom periods of the past has given way to a certain skepticism. It may be that businessmen will in the future react to credit expansion in a manner other than they have in the past. It may be that they will avoid using for an expansion of their operations the easy money available because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a definite statement.

In another direction the monetary theory of the trade cycle has certainly affected the course of events. Although no official--whether he works in the bureaus of a government’s financial services [p. 798] or of a central bank, or whether he teaches at a neo-orthodox university--is prepared to admit it, public opinion by and large no longer denies the two main theses of the circulation credit theory: viz., that the cause of the depression is the preceding boom and that this boom is engendered by credit expansion. The awareness of these facts alarms the financial press as soon as the first signs of the boom appear. Then even the authorities begin to talk about the necessity of preventing a further rise in prices and profits, and they really begin to restrict credit. The boom comes to an early end; a recession starts. The result has been that in the last decade the length of the cycle was considerably cut down. There was still an alternation of boom and slump, but the phases lasted a shorter time and succeeded one another more frequently. This is a far cry from the “classical” period of the ten and a half years of William Stanley Jevon’s crop cycle. And, most important, as the boom comes to an earlier end, the amount of malinvestment is smaller and in consequence the following depression is milder too.

The Chimera of Contracyclical Policies

An essential element of the “unorthodox” doctrines, advanced both by all socialists and by all interventionists, is that the recurrence of depressions is a phenomenon inherent in the very operation of the market economy. But while the socialists contend that only the substitution of socialism for capitalism can eradicate the evil, the interventionists ascribe to the government the power to correct the operation of the market economy in such a way as to bring about what they call “economic stability.” These interventionists would be right if their antidepression plans were to aim at a radical abandonment of credit expansion policies. However, they reject this idea in advance. What they want is to expand credit more and more and to prevent depressions by the adoption of special “contracyclical” measures.

In the contest of these plans the government appears as a deity that stands and works outside the orbit of human affairs, that is independent of the actions of its subjects, and has the power to interfere with these actions from without. It has at its disposal means and funds that are not provided by the people and can be freely used for whatever purposes the rulers are prepared to employ them for. What is needed to make the most beneficent use of this power is merely to follow the advice given by the experts.

The most advertised among these suggested remedies is contracyclical timing of public works and expenditure on public enterprises. The idea is not so new as its champions would have us believe. When depression came in the past, public opinion always asked the government to embark upon public works in order to create jobs and to [p. 799] stop the drop in prices. But the problem is how to finance these public works. If the government taxes the citizens or borrows from them, it does not add anything to what the Keynesians call the aggregate amount of spending. It restricts the private citizen’s power to consume or to invest to the same extent that it increases its own. If, however, the government resorts to the cherished inflationary methods of financing, it makes things worse, not better. It may thus delay for a short time the outbreak of the slump. But when the unavoidable payoff does come, the crisis is the heavier the longer the government has postponed it.

The interventionist experts are at a loss to grasp the real problems involved. As they see it, the main thing is “to plan public capital expenditure well in advance and to accumulate a shelf of fully worked out capital projects which can be put into operation at short notice.” This, they say, “is the right policy and one which we recommend all countries should adopt.”7  However, the problem is not to elaborate projects, but to provide the material means for their execution. The interventionists believe that this could be easily achieved by holding back government expenditure in the boom and increasing it when the depression comes.

Now, restriction of government expenditure may be certainly be a good thing. But it does not provide the funds a government needs for a later expansion of its expenditure. An individual may conduct his affairs in this way. He may accumulate savings when his income is high and spend them later when his income drops. But it is different with a nation or all nations together. The treasury may hoard a considerable part of the lavish revenue from taxes which flows into the public exchequer as a result of the boom. As far and as long as it withholds these funds from circulation, its policy is really deflationary and contracyclical and may to this extent weaken the boom created by credit expansion. But when these funds are spent again, they alter the money relation and create a cash-induced tendency toward a drop in the monetary unit’s purchasing power. By no means can these funds provide the capital goods required for the execution of the shelved public works.

The fundamental error of these projects consists in the fact that they ignore the shortage of capital goods. In their eyes the depression is merely caused by a mysterious lack of the people’s propensity both to consume and to invest. While the only real problem is to produce more and to consume less in order to increase the stock of capital goods available, the interventionists want to increase both consumption and investment. They want the government to embark upon projects which are unprofitable precisely because the factors of production [p. 800] needed for their execution must be withdrawn from other lines of employment in which they would fulfill wants the satisfaction of which the consumers consider more urgent. They do not realize that such public works must considerably intensify the real evil, the shortage of capital goods.

One could, of course, think of another mode for the employment of the savings the government makes in the boom period. The treasury could invest its surplus in buying large stocks of all those materials which it will later, when the depression comes, need for the execution of the public works planned and of the consumers’ goods which those occupied in these public works will ask for. But if the authorities were to act in this way, they would considerably intensify the boom, accelerate the outbreak of the crisis, and make its consequences more serious.8

All this talk about contracyclical government activities aims at one goal only, namely, to divert the public’s attention from cognizance of the real cause of the cyclical fluctuations of business. Ass governments are firmly committed to the policy of low interest rates, credit expansion, and inflation. When the unavoidable aftermath of these short-term policies appears, they know only of one remedy--to go on in inflationary ventures.

• 5 If a bank does not expand circulation credit by issuing additional fiduciary media (either in the form of banknotes or in the form of deposit currency), it can generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market. It merely makes a gift to debtors. The inference to be drawn from the monetary cycle theory by those who want to prevent the recurrence of booms and of the subsequent depressions is not that the banks should not lower the rate of interest, but that they should abstain from credit expansion. Of course, credit expansion necessarily entails a temporary downward movement of market interest rates. Professor Haberler (Prosperity and Depression, pp. 65-66) has completely failed to grasp this primary point, and thus his critical remarks are vain.
• 6Cf. Machlup, The Stock Market, Credit and Capital Formation, pp. 256-261
• 7 Cf. League of Nations, Economic Stability in the Post-War World, Report of the Delegation on Economic Depressions, Pt. II. (Geneva, 1945), p. 173.
• 8 In dealing with the contracyclical policies the interventionists always refer to the alleged success of these policies in Sweden. It is true that public capital expenditure in Sweden was actually doubled between 1932 and 1939. But this was not the cause, but an effect, of Sweden’s prosperity in the ‘thirties. This prosperity was entirely due to the rearmament of Germany. This Nazi policy increased the German demand for Swedish products on the one hand and restricted, on the other hand, German competition on the world market for those products which Sweden could supply. Thus Swedish exports increased from 1932 to 1938 (in thousands of tons): iron ore from 2,219 to 12,485; pig iron from 31,047 to 92,980; ferro-alloys from 15,453 to 28,605; other kinds of iron and steel from 134,237 to 256,146; machinery from 46,230 to 70,605. The number of unemployed applying for relief was 114,000 in 1932 and 165,000 in 1933. It dropped, as soon as German rearmament came into full swing, to 115,000 in 1934, to 62,000 in 1935, and was 16,000 in 1938. The author of this “miracle” was not Keynes, but Hitler.