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3.2. The Role of Money and Credit in Pre-Keynesian Business Cycle Literature

Hansen (1951) and Haberler (1958) provide excellent reviews of pre-Keynesian business cycle literature. Hansen takes a critical stance and largely dismisses pre-Keynesian theories5 in favour of a multiplier-accelerator approach, stressing in particular the role of investment. In so doing he plays down the roles of innovation, uncertainty and the financial system in cycle generation and propagation. He is particularly critical of Hayek's work (Hayek 1931), which is regarded by many as perhaps the major pre-Keynesian theory and which attaches weight to both monetary and real factors. In the previous chapter it was noted that proponents of equilibrium theories of the business cycle regard Hayek's work as a seminal contribution. Haberler is more cautious about the post-Keynesian multiplier-accelerator approach and, having reviewed the Keynesian and pre-Keynesian literature, provides his own synthetic exposition of the nature and causes of business cycles in which innovations, uncertainty and the monetary and financial systems feature more prominently. Haberler makes the following observation, for example:

Money and credit occupy such a central position in our economic system that it is almost certain that they play an important role in bringing about the business cycle, either as an impelling force or as a conditioning factor. (1958, p. 14)

Hansen (1951) traces concern over financial instability back to the early nineteenth century when "overtrading' became a common explanation of commercial and financial crises. The original source of the 'overtrading' idea appears to be Adam Smith (1776), who described it as a general error committed by large and small traders when the profits from trade happen to be greater than normal. Carey (1816) observed that banks contributed to and significantly amplified commercial and financial crises because, rather than checking the spirit of overtrading, they fostered and extended it by discounting freely on demand. Then at the first sign of crisis they abruptly changed their practice and adopted a dramatically opposite stance and diminished their loans violently and rapidly. Mill (1848) devoted three chapters to the causes and effects of commercial crises. He perceived of a crisis as a commercial phenomenon caused by speculation in commodities - often, but not always, backed by an irrational extension of bank credit. Later Mills (1867)6 stated categorically that every ten years or so a vast and sudden increase of demand in the loan market occurs, followed by a revulsion and a temporary destruction of credit or discredit, as it was sometimes called. He argued that the credit cycle breeds optimism which in turn breeds recklessness and leads to a crisis and stagnation. It was, therefore, governed by moral or psychological causes. Marshall and Marshall (1879) also regarded crises as being related to reckless inflation of credit, with the subsequent depressions attributed to a want of confidence which induced a state of commercial disorganisation. Hansen then turns to a critical review of the work of Hawtrey and Hayek, which he regards as monetary disequilibrium theories.

Haberler's review of the literature draws a useful distinction between purely monetary theories of the cycle, monetary over-investment theories and psychological theories, all of which attach importance to money and credit. In his view, Hawtrey's work7 is the leading example of a purely monetary theory. Hawtrey argues that changes in the flow of money are the sole and sufficient cause of changes in economic activity, including the alternation of prosperity and depression and good and bad trade. In his theory aggregate demand, or consumer outlay as he calls it, is related to the money supply via the Cambridge version of equation of exchange, in which income velocity replaces transactions velocity. Consequently changes in consumers' outlay are principally due to changes in the quantity of money and the business cycle is a replica, on a small scale, of an outright money inflation and deflation. Depression results from a fall in consumers' outlay in response to a reduction in the circulating medium of exchange8 and is intensified by a fall in the velocity of circulation. In prosperity the reverse holds. It follows that if the flow of money can be stabilised, cycles will disappear but, Hawtrey argues, stabilisation will not be easy because the modern money and credit system is inherently unstable. Hawtrey assumes that bank credit is the main means of payment and the money supply consists of bank credit and circulating legal tender. The banking system creates credit and regulates its quantity. The upswing of the trade cycle is caused by an expansion of credit brought about by banks through the easing of conditions attached to loans, including reductions in the discount rate.

Merchants are particularly sensitive to interest rate charges and play a strategic role in Hawtrey's theory. In the upswing prices will tend to rise, improving profitability, and so too will the velocity, thus reinforcing the expansionary tendencies. Prosperity is terminated when credit expansion is discontinued. In the expansionary phase the demand for transactions balances will increase, causing a drainage of cash from the banks and making them reliant on the central bank to alleviate the shortages. If the central bank declines to do so because of its exchange rate objective or out of concern over growing inflationary pressure, then the process of credit expansion will be terminated. The downswing that follows is also cumulative and is caused largely by a reversal of the processes prevailing in the upswing. During the depression, loans are liquidated, bank reserves accumulate, excess reserves build up, and interest rates fall to very low levels. Hawtrey argues that the abundance of cheap money, reinforced by central bank policy, will eventually spark a revival but acknowledges the possibility of a credit deadlock in which pessimism prevails. This he regards as a rare occurrence but one which can explain the drawn-out depression of the 1930s. Normally, however, banking policy can be relied upon to generate another upswing fairly soon after bank reserves have become excessive, and another over-expansion of credit will occur.

Haberler draws attention to the fact that Hawtrey's theory contends that changes in the rate of interest influence primarily the demand for working capital and particularly stocks of goods, hence the importance attached to merchants rather than investment in fixed capital. It is, therefore, distinguishable from monetary over-investment or neo-Wicksellian theories. In this category he places the work of Hayek (particularly 1931, 1933), among others.9 Like Hawtrey's, such theories assume that the banking system regulates the quantity of money and recognise a complicated relationship between the interest rate, changes in the quantity of money and the price level. Wicksell (1907, 1934, 1936) provides the basis for their analysis by drawing a distinction between the money, nominal or market rate of interest, which is influenced by monetary factors including the policy of banks, and the natural rate of interest. The latter is defined as the rate which equates the demand for loan capital with the supply of savings. If banks lower the market rate below the natural rate, the demand for credit will rise to exceed the supply of savings, leaving banks to expand credit to meet the excess demand, and inflation will result. If the market rate is raised above the natural rate, the demand for credit will fall and savings will not be used for productive purposes.

In monetary over-investment theories the boom is brought about by the market rate of interest falling below the natural rate, which leads to a credit expansion and rising prices. This encourages further borrowing and credit expansion, possibly by causing a reduction in the real interest rate.10 Monetary expansion through the increase of bank credit does not lead to a parallel increase in savings, and the natural or equilibrium rate of interest will tend to rise. If banks try to maintain the prevailing interest rate then the gap between it and the natural rate will rise, requiring even greater credit expansion to meet the growing excess demand for credit. Prices rise still higher, profits are raised further, and the inflationary spiral continues. So far the theory runs parallel with the purely monetary theory, Haberler observes.

Complementary to the monetary expansion-induced upswing, however, there will be distortions in the real sector because the rate of interest also influences the allocation of factors of production. As capitalism develops, with the ultimate goal of expanding the output of consumer goods, the process of production lengthens - in the sense of involving a greater number of intermediate stages in the production of intermediate goods such as machinery, components, raw materials and half-finished products. The percentage of capital stock in particular will tend to increase relative to the output of consumable goods, and entrepreneurs will tend to elongate the process of production in response to the availability of new capital and lower interest rates. If the rate of interest falls as a result of increased savings, then investment will increase, and the product in process will tend to lengthen.

The entrepreneur seeking to increase capital stock need not be concerned about whether the interest rate fall is due to an increase in voluntary saving or an expansion in bank credit. The fall in the interest rate will encourage investment, and means of production will be drawn away from consumption goods industries. This requires that the credit creation does not lead to an equivalent rise in the demand for consumer goods through rising aggregate income. Income may indeed rise but is assumed to do so after a lag so that prices will rise faster than disposable income and consumption will be curtailed. The rising prices and lower interest rates induce people to save more and result in 'forced saving' which, like voluntary saving, restricts consumption and releases productive resources for the production of additional capital goods.

According to the monetary over-investment theories, the process of monetary expansion and heavy investment cannot go on indefinitely because the artificial lowering of the interest rate encourages a lengthening of production which cannot continue unchecked. The structure of production becomes top-heavy as a result of over-investment, and it is increasingly evident that further investment should be curtailed; the investment boom then collapses. The proximate cause for the breakdown of the boom, Haberler observes, is normally attributed to the inability or unwillingness of the banking system to continue to expand credit. The mere stoppage of expansion can cause a collapse because of the long gestation of newly started investment projects which rely on the availability of credit over a long period. If the flow of credit is not forthcoming, the completion of new schemes becomes impossible, and this means that various sectors may not be able to work at full capacity because of inadequate demand as a result of input-output relationships.

Members of the over-investment school argue that the problem is not a purely monetary one; consequently, monetary measures cannot avert the crisis but can only postpone it, Haberler observes. The sustained monetary expansion would instead lead to inflation and then hyperinflation and the complete collapse of the monetary system. According to Haberler, Hayek provides the most elaborate analysis of the monetary over-investment process. At the end of the boom, near-full employment is likely to prevail, and it is postulated that there will be an increase in the demand for consumer goods relative to that for producer goods. It is not totally clear why this should occur. Hayek attaches importance to historic cost accounting which inflates the paper profits of entrepreneurs, tempting them to increase consumption, but the lagged effect of the over- investment boom on incomes might also stimulate consumer goods demands. The relative increase in demand for consumer goods will ensure that consumer goods industries' profitability will increase relative to that of producer goods industries, and factors of production will be bid away from 'higher' stages of production to 'lower' stages.

This rise, Hayek argues, increases the production costs of the higher stages of production more than it does those of the lower stages, and a breakdown in the investment-led expansion process can be expected. It can be averted only if people can be induced to save more and consume less, and the rise in interest rates is judged by adherents to the monetary over-investment school to be insufficient to achieve this. They therefore conclude that every credit expansion will lead to over- investment and to a breakdown, and that it is impossible to achieve a continuous increase in the capital stock by means of 'forced' saving accomplished with the help of inflationary credit expansion. No collapse need occur if credit expansion and forced saving could continue indefinitely; but forced saving, it is argued, will end abruptly because the continuous expansion of credit will lead to accelerating inflation which will threaten the collapse of the monetary system.

Haberler feels that the explanation of the crisis in the monetary overinvestment theories is incomplete and that the theory of the depression is not as fully elaborated as the theory of the boom. The theories vary in the weight attached to monetary and non-monetary factors, such as the need to adjust the over-elongated process of production. Some (e.g. Strigl 1934) argue that after the breakdown of the boom, banks will not merely halt credit expansion but will go further and contract credit in order to restore their liquidity. Influenced by widespread insecurity and pessimism, firms will also seek to strengthen their cash reserves. The general struggle to increase liquidity will induce hoarding. Prices will begin to fall, and the incentive to invest will be further reduced. Following the collapse of the boom, the money rate of interest will tend to rise above the natural rate but, as the banks' liquidity position improves, the price fall comes to an end, pessimism gives way to a more optimistic outlook, the natural and market rates converge, and a state of equilibrium is approached. No special stimulus from outsiders, such as innovations or other shocks, is required. Haberler observes that the new upswing starts smoothly and imperceptibly out of the ashes of the last boom.

The behaviour of the banking system is crucial to the recurrence of such cycles of prosperity and depression. Mises (1928, pp. 56-61) argues that if the banks did not push the money rate below the natural rate by expanding credit, equilibrium would not be disturbed. It is therefore necessary to explain why the banks keep repeating their mistake. Mises contends that the root cause is an ideological preference for interest rate reduction and credit expansion among businessmen and politicians. He further argues that the banking system's ability to expand credit relies on central bank support, which in turn is reliant on its monopoly over the issuance of banknotes. If banks issued their own notes, unsound banks would be eliminated and sound banks would not indulge in imprudent credit expansion for fear of bankruptcy. Other exponents of the theory tend to believe that the solution is not this simple" because the problem is not always that banks reduce nominal rates below the natural rates. Instead the natural rate may rise above the prevailing nominal rate. Machlup (1931, pp. 167-78), for example, assumes a more passive role for banks, especially in the boom phase of the cycle, while trying to explain the recurrence of the cycle.

Haberler also considers over-indebtedness as a cause of the recurrence of economic depressions. He concentrates on the work of Fisher (1933), who argues that over-indebtedness and deflation tend to reproduce and reinforce one another, deflation swelling the burden of debts and over-indebtedness leading to debt liquidation, which in turn leads to a contraction in the money stream and a fall in prices. As noted in section 1.2, Fisher regarded the business cycle as a myth, in the sense that there is no regular periodic movement. He stresses the differing periods and amplitudes of the so-called cycles, regarding each one as a historical event. Nevertheless, he accepts that the economic system is subject to spirals of expansion and contraction. His description of the downward spiral which follows the onset of a depression is essentially similar to that of the purely monetary and monetary over-investment schools. Debts and over-indebtedness, however, play a crucial and destructive role in his theory. Large debts tend to intensify the deflation and over-indebtedness may be the cause that precipitates the crisis, Haberler observes.

The burden of debts aggravates depressions because it becomes heavier as prices fall and leads to distress selling and further falls in prices. Fisher argues that over-indebtedness occurs when debts are too large in relation to other economic factors and commonly occurs when opportunities to invest at large prospective profits appear, perhaps due to innovations and the opening of new markets. Easy money is seen as the main cause of over-borrowing. Haberler observes that there is, therefore, a close connection between over-investment, which implies investment that later turns out to be unprofitable, and over-indebtedness. However, he stresses the fact that over-investment has relied on borrowed money. Fisher's theory consequently adds to the monetary over-investment theory only to the extent that it stresses that debt can intensify the depression that would be expected in an over-investment cycle which relied entirely on internally generated funds, Haberler argues. But monetary over-investment theories tend to assume a role for bank credit in the funding of overinvestment anyway.

Haberler next turns to the discussion of 'psychological theories, noting that there is no fundamental difference between these theories and other economic theories, which all make assumptions about human behaviour. The distinction he draws, however, is the following:

The 'psychological' theories introduce certain assumptions about typical reactions, mainly on the part of the entrepreneur and the saver, in certain situations; and these reactions are conventionally called psychological, because of their (in a sense) indeterminate character. (1958, pp. 142, 143)

But the distinction is one of emphasis rather than of kind, he notes. The psychological factors are used to supplement monetary and other economic determinants of business cycles and not as alternative elements of causation. They often feature less prominently, however, in other theories. The main channel through which psychological factors have an influence is that of expectations formation under uncertainty which, Haberler argues, is pervasive. But it does feature prominently in such activities as investment. He observes that the psychological theories essentially introduce optimism and pessimism as additional, intensifying determinants of the prosperity and depression phases of the cycle respectively, and the turning points are marked by a switch from optimism to pessimism and vice versa.

Haberler notes that the psychological factor will reduce the stability of the relationship between investment and the rate of interest and can stimulate or encourage investment independently, as Keynes (1936) argued. Further, the optimism can become infectious, leading entrepreneurs into irrational herd behaviour. Lavington (1922, pp. 32-3) likens businessmen who infect each other with optimism to skaters on a pond, whose confidence in their own safety is reinforced by the presence of other skaters on the ice despite the rational judgment that the greater the number of skaters on the ice the higher the risk of it breaking. Haberler observes that psychological theories also direct attention to the fact that following a period of rising prices and demand economic agents come to expect further rises in the future and this conditions their behaviour. This 'psychological fact' features prominently in the discussion of price bubbles and the financial instability hypothesis (FIH) in the subsequent sections of this chapter. Haberler also notes that theorists stressing psychological factors, especially Keynes (1936) and Pigou (1929, for example), point out that the discovery of 'errors of optimism' gives birth to the opposite 'error of pessimism1. Reviewing Pigou's work, Hawtrey (1928) argues that optimism and pessimism are wholly dependent on the policy of banks. They are optimistic when credit is rising and pessimistic when it is falling. This ignores the fact that reactions of investment to changes in interest rates may vary according to the circumstance, particularly in accordance with Keynes's "animal spirits' (1936, p. 162); and the banks' behaviour also needs to be explained, perhaps in terms of infection by optimism and pessimism from businessmen.

Having reviewed the above and other theories of the business cycle, in which the financial system plays no major role, Haberler presents a synthetic exposition of the nature and causes of business cycles which basically incorporates money and the banking system in a Keynesian model in which the multiplier and accelerator are operative. He concludes that:

... a large part of contemporary economic theory has laid undue stress on 'real' factors and that 'monetary' factors . have been neglected and their importance grossly underestimated. (1958, p. 455)

By contemporary theory he means the Keynesian multiplier-accelerator literature in particular. He notes that not only have purely monetary theories become increasingly unpopular but also that, despite the fact that most current theories are mixed in the sense that monetary and real factors interact, the monetary factor has been increasingly de-emphasised and relegated to a passive or permissive role. He cites Hicks (1950) as an example. In contrast he believes that monetary factors and policies play an important role in generating economic instability and that speculative excesses occur, in both the real and financial spheres, which are not possible on the large and disturbing scale on which they actually occur without excessive credit expansion. By 'monetary factors' he means not just active policies of inflation and deflation but also the monetary repercussions of financial crises which frequently mark the upper turning point of the cycle. He asserts that: the acceleration principle plus multiplier, unless combined with and reinforced by monetary factors, psychology and rigidities would hardly produce more than mild inconsequential fluctuations. (1958, p. 481)

He further argues that the propagation problem is more important than the impulse problem12 and that in the propagation mechanism, which describes how the economy reacts to shocks, monetary factors play a decisive role. With regard to the impulse problem, innovations are regarded as a particularly important source of shocks. Haberler (1958) also warned prophetically that in an environment with a low tolerance for unemployment and a fear of depression, policies based on the Keynesian models of the 1940s and 1950s might ultimately lead to a secular inflation.

The pre-Keynesian literature is therefore replete with theories that attach a major role to money and the banking system in the cycle generation process. In the next section more recent work, which attempts to develop some of these themes, is discussed. The financial instability hypothesis, in particular, develops the idea that bank behaviour encourages over-expansion in the upswing. This leads to its eventual termination by a crisis which ushers in a more severe recession, and perhaps even a depression, than might otherwise have occurred. It seems to describe the 2007-9 Global Financial Crisis very well.

 
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