The General Theory of Employment, Interest and Money Part 10

Moreover, it is only in highly exceptional circ.u.mstances that an increase in the quant.i.ty of money will be a.s.sociated with a decrease in the quant.i.ty of effective demand.

The ratio between the quant.i.ty of effective demand and the quant.i.ty of money closely corresponds to what is often called the 'income-velocity of money';?except that effective demand corresponds to the income the expectation of which has set production moving, not to the actually realised income, and to gross, not net, income. But the 'income-velocity of money' is, in itself, merely a name which explains nothing. There is no reason to expect that it will be constant. For it depends, as the foregoing discussion has shown, on many complex and variable factors. The use of this term obscures, I think, the real character of the causation, and has led to nothing but confusion.

(2) As we have shown above (Chapter 4), the distinction between diminishing and constant returns partly depends on whether workers are remunerated in strict proportion to their efficiency. If so, we shall have constant labour-costs (in terms of the wage-unit) when employment increases. But if the wage of a given grade of labourers is uniform irrespective of the efficiency of the individuals, we shall have rising labour-costs, irrespective of the efficiency of the equipment. Moreover, if equipment is non- h.o.m.ogeneous and some part of it involves a greater prime cost per unit of output, we shall have increasing marginal prime costs over and above any increase due to increasing labour-costs.

Hence, in general, supply price will increase as output from a given equipment is increased. Thus increasing output will be a.s.sociated with rising prices, apart from any change in the wage-unit.

(3) Under (2) we have been contemplating the possibility of supply being imperfectly elastic. If there is a perfect balance in the respective quant.i.ties of specialised unemployed resources, the point of full employment will be reached for all of them simultaneously. But, in general, the demand for some services and commodities will reach a level beyond which their supply is, for the time being, perfectly inelastic, whilst in other directions there is still a substantial surplus of resources without employment.

Thus as output increases, a series of 'bottle-necks' will be successively reached, where the supply of particular commodities ceases to be elastic and their prices have to rise to whatever level is necessary to divert demand into other directions.

It is probable that the general level of prices will not rise very much as output increases, so long as there are available efficient unemployed resources of every type. But as soon as output has increased sufficiently to begin to reach the 'bottle-necks', there is likely to be a sharp rise in the prices of certain commodities. Under this heading, however, as also under heading (2), the elasticity of supply partly depends on the elapse of time. If we a.s.sume a sufficient interval for the quant.i.ty of equipment itself to change, the elasticities of supply will be decidedly greater eventually. Thus a moderate change in effective demand, coming on a situation where there is widespread unemployment, may spend itself very little in raising prices and mainly in increasing employment; whilst a larger change, which, being unforeseen, causes some temporary 'bottle-necks' to be reached, will spend itself in raising prices, as distinct from employment, to a greater extent at first than subsequently.

(4) That the wage-unit may tend to rise before full employment has been reached, requires little comment or explanation. Since each group of workers will gain, cet. par., by a rise in its own wages, there is naturally for all groups a pressure in this direction, which entrepreneurs will be more ready to meet when they are doing better business. For this reason a proportion of any increase in effective demand is likely to be absorbed in satisfying the upward tendency of the wage-unit.

Thus, in addition to the final critical point of full employment at which money-wages have to rise, in response to an increasing effective demand in terms of money, fully in proportion to the rise in the prices of wage-goods, we have a succession of earlier semi-critical points at which an increasing effective demand tends to raise money-wages though not fully in proportion to the rise in the price of wage-goods; and similarly in the case of a decreasing effective demand. In actual experience the wage- unit does not change continuously in terms of money in response to every small change in effective demand; but discontinuously. These points of discontinuity are determined by the psychology of the workers and by the policies of employers and trade unions. In an open system, where they mean a change relatively to wage-costs elsewhere, and in a trade cycle, where even in a closed system they may mean a change relatively to expected wage-costs in the future, they can be of considerable practical significance. These points, where a further increase in effective demand in terms of money is liable to cause a discontinuous rise in the wage-unit, might be deemed, from a certain point of view, to be positions of semi-inflation, having some a.n.a.logy (though a very imperfect one) to the absolute inflation (cf. Chapter 21 below) which ensues on an increase in effective demand in circ.u.mstances of full employment. They have, moreover, a good deal of historical importance. But they do not readily lend themselves to theoretical generalisations.

(5) Our first simplification consisted in a.s.suming that the remunerations of the various factors entering into marginal cost all change in the same proportion. But in fact the rates of remuneration of different factors in terms of money will show varying degrees of rigidity and they may also have different elasticities of supply in response to changes in the money-rewards offered. If it were not for this, we could say that the price-level is compounded of two factors, the wage-unit and the quant.i.ty of employment.

Perhaps the most important element in marginal cost which is likely to change in a different proportion from the wage-unit, and also to fluctuate within much wider limits, is marginal user cost. For marginal user cost may increase sharply when employment begins to improve, if (as will probably be the case) the increasing effective demand brings a rapid change in the prevailing expectation as to the date when the replacement of equipment will be necessary.

Whilst it is for many purposes a very useful first approximation to a.s.sume that the rewards of all the factors entering into marginal prime-cost change in the same proportion as the wage-unit, it might be better, perhaps, to take a weighted average of the rewards of the factors entering into marginal prime- cost, and call this the cost-unit. The cost-unit, or, subject to the above approximation, the wage-unit, can thus be regarded as the essential standard of value; and the price-level, given the state of technique and equipment, will depend partly on the cost-unit, and partly on the scale of output, increasing, where output increases, more than in proportion to any increase in the cost-unit, in accordance with the principle of diminishing returns in the short period. We have full employment when output has risen to a level at which the marginal return from a representative unit of the factors of production has fallen to the minimum figure at which a quant.i.ty of the factors sufficient to produce this output is available.

V.

When a further increase in the quant.i.ty of effective demand produces no further increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation.

Up to this point the effect of monetary expansion is entirely a question of degree, and there is no previous point at which we can draw a definite line and declare that conditions of inflation have set in.

Every previous increase in the quant.i.ty of money is likely, in so far as it increases effective demand, to spend itself partly in increasing the cost-unit and partly in increasing output.

It appears, therefore, that we have a sort of asymmetry on the two sides of the critical level above which true inflation sets in. For a contraction of effective demand below the critical level will reduce its amount measured in cost-units; whereas an expansion of effective demand beyond this level will not, in general, have the effect of increasing its amount in terms of cost-units. This result follows from the a.s.sumption that the factors of production, and in particular the workers, are disposed to resist a reduction in their money-rewards, and that there is no corresponding motive to resist an increase. This a.s.sumption is, however, obviously well founded in the facts, due to the circ.u.mstance that a change, which is not an all-round change, is beneficial to the special factors affected when it is upward and harmful when it is downward.

If, on the contrary, money-wages were to fall without limit whenever there was a tendency for less than full employment, the asymmetry would, indeed, disappear. But in that case there would be no resting- place below full employment until either the rate of interest was incapable of falling further or wages were zero. In fact we must have some factor, the value of which in terms of money is, if not fixed, at least sticky, to give us any stability of values in a monetary system.

The view that any increase in the quant.i.ty of money is inflationary (unless we mean by inflationary merely that prices are rising) is bound up with the underlying a.s.sumption of the cla.s.sical theory that we are always in a condition where a reduction in the real rewards of the factors of production will lead to a curtailment in their supply.

VI.

With the aid of the notation introduced in Chapter 20 we can, if we wish, express the substance of the above in symbolic form.

Let us write MV = D where M is the quant.i.ty of money, V its income-velocity (this definition differing in the minor respects indicated above from the usual definition) and D the effective demand. If, then, V is constant, prices will change in the same proportion as the quant.i.ty of money provided that ep ( = (Dpd) / (pdD)) is unity. This condition is satisfied (see Chapter 20 above) if eo = 0 or if ew = 1. The condition ew = 1 means that the wage-unit in terms of money rises in the same proportion as the effective demand, since ew = (DdW) / (WdD) and the condition eo = 0 means that output no longer shows any response to a further increase in effective demand, since eo = (DdO) / (OdD). Output in either case will be unaltered. Next, we can deal with the case where income-velocity is not constant, by introducing yet a further elasticity, namely the elasticity of effective demand in response to changes in the quant.i.ty of money, MdD ed = ????

DdM This gives us Mdp ???? = ep ed where ep = 1 ? ee eo(1 ? ew); pdM so that e = ed ? (1 ? ew)ed eeeo = ed(1 ? ee eo + ee eo ew) where e without suffix (= (Mdp) / (pdM)) stands for the apex of this pyramid and measures the response of money-prices to changes in the quant.i.ty of money.

Since this last expression gives us the proportionate change in prices in response to a change in the quant.i.ty of money, it can be regarded as a generalised statement of the quant.i.ty theory of money. I do not myself attach much value to manipulations of this kind; and I would repeat the warning, which I have given above, that they involve just as much tacit a.s.sumption as towhat variables are taken as independent (partial differentials being ignored throughout) as does ordinary discourse, whilst I doubt if they carry us any further than ordinary discourse can. Perhaps the best purpose served by writing them down is to exhibit the extreme complexity of the relationship between prices and the quant.i.ty of money, when we attempt to express it in a formal manner. It is, however, worth pointing out that, of the four terms ed, ew, ee and eo upon which the effect on prices of changes in the quant.i.ty of money depends, ed stands for the liquidity factors which determine the demand for money in each situation, ew for the labour factors (or, more strictly, the factors entering into prime-cost) which determine the extent to which money-wages are raised as employment increases, and ee and eo for the physical factors which determine the rate of decreasing returns as more employment is applied to the existing equipment.

If the public hold a constant proportion of their income in money, ed = 1; if money-wages are fixed, ew = 0; if there are constant returns throughout so that marginal return equals average return, ee eo = 1; and if there is full employment either of labour or of equipment, ee eo = 0.

Now e = 1, if ed = 1, and ew = 1; or if ed = 1, ew = 0 and ee eo = 0; or if ed = 1 and eo = 0.

And obviously there is a variety of other special eases in which e = 1. But in general e is not unity; and it is, perhaps, safe to make the generalisation that on plausible a.s.sumptions relating to the real world, and excluding the case of a 'flight from the currency' in which ed and ew become large, e is, as a rule, less than unity.

VII.

So far, we have been primarily concerned with the way in which changes in the quant.i.ty of money affect prices in the short period. But in the long run is there not some simpler relationship?

This is a question for historical generalisation rather than for pure theory. If there is some tendency to a measure of long-run uniformity in the state of liquidity-preference, there may well be some sort of rough relationship between the national income and the quant.i.ty of money required to satisfy liquidity- preference, taken as a mean over periods of pessimism and optimism together. There may be, for example, some fairly stable proportion of the national income more than which people will not readily keep in the shape of idle balances for long periods together, provided the rate of interest exceeds a certain psychological minimum; so that if the quant.i.ty of money beyond what is required in the active circulation is in excess of this proportion of the national income, there will be a tendency sooner or later for the rate of interest to fall to the neighbourhood of this minimum. The falling rate of interest will then, cet. par., increase effective demand, and the increasing effective demand will reach one or more of the semi-critical points at which the wage-unit will tend to show a discontinuous rise, with a corresponding effect on prices. The opposite tendencies will set in if the quant.i.ty of surplus money is an abnormally low proportion of the national income. Thus the net effect of fluctuations over a period of time will be to establish a mean figure in conformity with the stable proportion between the national income and the quant.i.ty of money to which the psychology of the public tends sooner or later to revert.

These tendencies will probably work with less friction in the upward than in the downward direction.

But if the quant.i.ty of money remains very deficient for a long time, the escape will be normally found in changing the monetary standard or the monetary system so as to raise the quant.i.ty of money, rather than in forcing down the wage-unit and thereby increasing the burden of debt. Thus the very long-run course of prices has almost always been upward. For when money is relatively abundant, the wage-unit rises; and when money is relatively scarce, some means is found to increase the effective quant.i.ty of money.

During the nineteenth century, the growth of population and of invention, the opening-up of new lands, the state of confidence and the frequency of war over the average of (say) each decade seem to have been sufficient, taken in conjunction with the propensity to consume, to establish a schedule of the marginal efficiency of capital which allowed a reasonably satisfactory average level of employment to be compatible with a rate of interest high enough to be psychologically acceptable to wealth-owners.

There is evidence that for a period of almost one hundred and fifty years the long-run typical rate of interest in the leading financial centres was about 5 per cent, and the gilt-edged rate between 3 and 3 per cent; and that these rates of interest were modest enough to encourage a rate of investment consistent with an average of employment which was not intolerably low. Sometimes the wage-unit, but more often the monetary standard or the monetary system (in particular through the development of bank-money), would be adjusted so as to ensure that the quant.i.ty of money in terms of wage-units was sufficient to satisfy normal liquidity-preference at rates of interest which were seldom much below the standard rates indicated above. The tendency of the wage-unit was, as usual, steadily upwards on the whole, but the efficiency of labour was also increasing. Thus the balance of forces was such as to allow a fair measure of stability of prices;?the highest quinquennial average for Sauerbeck's index number between 1820 and 1914 was only 50 per cent above the lowest. This was not accidental. It is rightly described as due to a balance of forces in an age when individual groups of employers were strong enough to prevent the wage-unit from rising much faster than the efficiency of production, and when monetary systems were at the same time sufficiently fluid and sufficiently conservative to provide an average supply of money in terms of wage-units which allowed to prevail the lowest average rate of interest readily acceptable by wealth-owners under the influence of their liquidity-preferences. The average level of employment was, of course, substantially below full employment, but not so intolerably below it as to provoke revolutionary changes.

To-day and presumably for the future the schedule of the marginal efficiency of capital is, for a variety of reasons, much lower than it was in the nineteenth century. The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quant.i.ty of money. So long as a tolerable level of employment could be attained on the average of one or two or three decades merely by a.s.suring an adequate supply of money in terms of wage-units, even the nineteenth century could find a way. If this was our only problem now?if a sufficient degree of devaluation is all we need?we, to-day, would certainly find a way. But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quant.i.ty of money. From the percentage gain, which the schedule of marginal efficiency of capital allows the borrower to expect to earn, there has to be deducted (1) the cost of bringing borrowers and lenders together, (2) income and sur-taxes and (3) the allowance which the lender requires to cover his risk and uncertainty, before we arrive at the net yield available to tempt the wealth-owner to sacrifice his liquidity. If, in conditions of tolerable average employment, this net yield turns out to be infinitesimal, time-honoured methods may prove unavailing.

To return to our immediate subject, the long-run relationship between the national income and the quant.i.ty of money will depend on liquidity-preferences. And the long-run stability or instability of prices will depend on the strength of the upward trend ofthe wage-unit (or, more precisely, of the cost- unit) compared with the rate of increase in the efficiency of the productive system.

Chapter 22.

NOTES ON THE TRADE CYCLE.

Since we claim to have shown in the preceding chapters what determines the volume of employment at any time, it follows, if we are right, that our theory must be capable of explaining the phenomena of the trade cycle.

If we examine the details of any actual instance of the trade cycle, we shall find that it is highly complex and that every element in our a.n.a.lysis will be required for its complete explanation. In particular 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 best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by a.s.sociated changes in the other significant short- period variables of the economic system. To develop this thesis would occupy a book rather than a chapter, and would require a close examination of facts. But the following short notes will be sufficient to indicate the line of investigation which our preceding theory suggests.

I.

By a cyclical movement we mean that as the system progresses in, e.g. the upward direction, the forces propelling it upwards at first gather force and have a c.u.mulative 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 subst.i.tution 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 subst.i.tuted 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 a.s.sociated 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 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 a.s.sets 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-a.s.sets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force. Nloreover, 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 a.s.sociated 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 a.s.sociated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

It is this, indeed, 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.

This brings me to my point. 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 a.s.sets 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 falling 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 pa.s.s 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 a.s.sets 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 acc.u.mulation 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 c.u.mulative influence in the downward direction.

In the earliest phase of a typical 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 pa.s.sed there is likely to be a further disinvestment in stocks which partially offsets reinvestment in working-capital; and, 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.

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 cla.s.s 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 incomes. 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 circ.u.mstance, 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 c.u.mulates 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 wlaen 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.

III.

The preceding a.n.a.lysis may appear to be in conformity with the view of those who hold that over- investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, whilst for the reasons given above the slump cannot be prevented by a low rate of interest, nevertheless the boom can be avoided by a high rate of interest.

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

To infer these conclusions from the above would, however, misinterpret my a.n.a.lysis; and would, according to my way of thinking, involve serious error. For the term 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. 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 a.n.a.lysis, 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-a.s.sets 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 per cent in conditions of full employment are made in the expectation of a yield of; say, 6 per cent, 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 per cent 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 per cent 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! 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, a.s.suming 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 a.s.sert 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 a.s.sociated in countries so wealthy as Great Britain or the United States with a volume of new investment, a.s.suming 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 a.s.sert 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 a.s.sociated 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 condition 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.

Moreover, I should readily concede that 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, I should support at the same time all sorts of policies for increasing the propensity to consume. 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 ill.u.s.tration?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 90 per cent of it consumption?if, furthermore, net investment would have to rise 50 per cent 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 90 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 90 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 seems to me to be 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, I think, strong that the great majority of individuals would prefer increased income to increased leisure; and I see no sufficient reason for compelling those who would prefer more income to enjoy more leisure.

VI.

It may appear extraordinary that a school of thought should exist which finds the solution for the trade cycle in checking the boom in its early stages by a higher rate of interest. The only line of argument, along which any justification for this policy can be discovered, is that put forward by Mr D. H.

Robertson, who a.s.sumes, in effect, that full employment is an impracticable ideal and that 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 a.s.sume, 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 a.s.sumptions; 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, or at least a.s.sumes, 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 a.s.sociated 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 quant.i.ty 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 a.s.sumption that aggregate output is incapable of change. But a theory which a.s.sumes constant output is obviously not very serviceable for explaining the trade cycle. VII In the earlier studies of the trade cycle, notably by J evons, 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 to-day 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. Jevons's theory, that the trade cycle was primarily due to the fluctuations in the bounty of the harvest, can be re-stated as follows. When an exceptionally large harvest is gathered in, an important addition is usually made to the quant.i.ty 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. That is to say, 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. And 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. I should attribute the slow rate of recovery from a slump, after the turning-point has been reached, mainly to the deflationary effect of the reduction of redundant stocks to a normal level. At first the acc.u.mulation 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, indeed, 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 const.i.tuted 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.

Chapter 23.