America's Great Depression (18 page)

The emphasis of the Banking School, however, is invalid. The important aspect of bank credit expansion is the
quantity
of new money thrown into business lending, and not at all the
type
of business loans that are made. Short-term, “self-liquidating” loans are just as inflationary as long-term loans. Credit needs of business, on the other hand, can be financed by borrowing from voluntary savings;
Some Alternative Explanations of Depression: A Critique
77

there is no good reason why short-term loans in particular should be financed by bank inflation. Banks do not simply passively await business firms demanding loans; these very demands vary inversely to the rate of interest that the banks charge. The crucial point is the injection of new money into business firms; regardless of the type of business loan made, this money will then seep into the economy, with the effects described in the Austrian analysis. The irrelevance of the
type
of loan may be seen from the fact that business firms, if they wish to finance long-term investment, can finance it
indirectly
from the banks just as effectively as from direct loans. A firm may simply cease using its own funds for financing short-term inventory, and instead borrow the funds from the banks. The funds released by this borrowing can then be used to make long-term investments. It is impossible for banks to prevent their funds being used indirectly in this manner. All credit is interrelated on the market, and there is no way that the various types of credit can be hermetically sealed from each other.27 And even if there were, it would make no economic sense to do so.

In short, the “self-liquidating” loan is just as inflationary as any other type of loan, and the only merit of this theory is the indirect one of quantitatively limiting the lending of banks that cannot find as many such loans as they would like. This loan does not even have the merit of speedier retirement, since short-term loans can and are renewed or reloaned elsewhere, thus perpetuating the loan for as long a time as any “long-term” loan. This emphasis of the Banking School weakened its salutary effect in the 1920s, for it served to aggravate the general over-emphasis on
types
of loans—in 27Thus, during the late 1920s, when banks, influenced by qualitative credit doctrines, tried to shut off the flow of credit to the stock market specifically, the market was able to borrow from the swollen funds of non-bankers, funds swollen by years of bank credit inflation.

On the fallacies of the qualitative credit theorists, and of their views on the stock market, see the excellent study by Fritz Machlup, who at that time was a leading Austrian School theorist,
The Stock Market, Credit and Capital Formation
(New York: Macmillan, 1940).

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particular the stock market—as against the quantity of money outstanding.

More dangerous than the Banking School in this qualitative emphasis are those observers who pick out some type of credit as being particularly grievous. Whereas the Banking School opposed a quantitative inflation that went into any but stringently self-liquidating assets, other observers care not at all about quantity, but only about some particular type of asset—e.g., real estate or the stock market. The stock market was a particular whipping boy in the 1920s and many theorists called for restriction on stock loans in contrast to “legitimate” business loans. A popular theory accused the stock market of “absorbing” capital credit that would otherwise have gone to “legitimate” industrial or farm needs.

“Wall Street” had been a popular scapegoat since the days of the Populists, and since Thorstein Veblen had legitimated a fallacious distinction between “finance” and “industry.” The “absorption of capital” argument is now in decline, but there are still many economists who single out the stock market for attack. Clearly, the stock market is a channel for investing in industry. If A buys a new security issue, then the funds are directly invested; if he buys an old share, then (1) the increased price of stock will encourage the firm to float further stock issues, and (2) the funds will then be transferred to the seller B, who in turn will consume or directly invest the funds. If the money is directly invested by B, then once again the stock market has channelled savings into investment. If B consumes the money, then his consumption or dissaving just offsets A’s saving, and no aggregate net saving has occurred.

Much concern was expressed in the 1920s over brokers’ loans, and the increased quantity of loans to brokers was taken as proof of credit absorption in the stock market. But a broker only
needs
a loan when his client calls on him for cash after selling his stock; otherwise, the broker will keep an open book account with no need for cash. But when the client needs cash he sells his stock and gets out of the market. Hence, the higher the volume of brokers’ loans from banks, the greater the degree that funds are
leaving
the stock market rather than entering it. In the 1920s, the high volume of
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79

brokers’ loans indicated the great degree to which industry was using the stock market as a channel to acquire saved funds for investment.28

The often marked fluctuations of the stock market in a boom and depression should not be surprising. We have seen the Austrian analysis demonstrate that greater fluctuations will occur in the capital goods industries. Stocks, however, are
units of title to
masses of capital goods
. Just as capital goods’ prices tend to rise in a boom, so will the prices of titles of ownership to masses of capital.29 The fall in the interest rate due to credit expansion raises the capital value of stocks, and this increase is reinforced both by the actual and the prospective rise in business earnings. The discounting of higher prospective earnings in the boom will naturally tend to raise stock prices further than most other prices. The stock market, therefore, is not really an independent element, separate from or actually disturbing, the industrial system. On the contrary, the stock market tends to reflect the “real” developments in the business world. Those stock market traders who protested during the late 1920s that their boom simply reflected their “investment in America” did not deserve the bitter comments of later critics; their error was the universal one of believing that the boom of the 1920s was natural and perpetual, and not an artificially-induced prelude to disaster. This mistake was hardly unique to the stock market.

Another favorite whipping-boy during recent booms has been
installment credit to consumers.
It has been charged that installment loans to consumers are somehow uniquely inflationary and unsound. Yet, the reverse is true. Installment credit is no more inflationary than any other loan, and it does far less harm than business loans (including the supposedly “sound” ones) because it 28On all this, see Machlup,
The Stock Market, Credit, and Capital Formation.
An individual broker might borrow in order to pay another broker, but in the aggregate, inter-broker transactions cancel out and total brokers’ loans reflect only broker-customer relations.

29Real estate values will often behave similarly, real estate conveying units of title of capital in land.

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does not lead to the boom–bust cycle. The Mises analysis of the business cycle traces causation back to inflationary expansion of credit
to business
on the loan market. It is the expansion of credit to business that overstimulates investment in the higher orders, misleads business about the amount of savings available, etc. But loans to consumers
qua
consumers have no ill effects. Since they stimulate consumption rather than business spending, they do not set a boom–bust cycle into motion. There is less to worry about in such loans, strangely enough, than in any other.

OVEROPTIMISM AND OVERPESSIMISM

Another popular theory attributes business cycles to alternating psychological waves of “overoptimism” and “overpessimism.” This view neglects the fact that the market is geared to reward correct forecasting and penalize poor forecasting. Entrepreneurs do not have to rely on their own psychology; they can always refer their actions to the objective tests of profit and loss. Profits indicate that their decisions have borne out well; losses indicate that they have made grave mistakes. These objective market tests check any psychological errors that may be made. Furthermore, the successful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors,
unless
objective facts of the market are distorted over a considerable period of time. Such distortion will hobble the objective “signals” of the market and mislead the great bulk of entrepreneurs. This is the distortion explained by Mises’s theory of the cycle. The prevailing optimism is not the cause of the boom; it is the reflection of events that seem to offer boundless prosperity.

There is, furthermore, no reason for general overoptimism to shift suddenly to overpessimism; in fact, as Schumpeter has pointed out (and this was certainly true after 1929) businessmen usually persist in dogged and unwarranted optimism for quite a while after a depression breaks out.30 Business psychology is, therefore, derivative 30See Schumpeter,
Business Cycles,
vol. 1, chap. 4.

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81

from, rather than causal to, the objective business situation. Economic expectations are therefore self-
correcting
, not self-aggravating. As Professor Bassic has pointed out:

The businessman may expect a decline, and he may cut his inventories, but he will produce enough to fill the orders he receives; and as soon as the expectations of a decline prove to be mistaken, he will again rebuild his inventories . . . the whole psychological theory of the business cycle appears to be hardly more than an inversion of the real causal sequence. Expectations more nearly derive from objective conditions than produce them. The businessman both expands and expects that his expansion will be profitable because the conditions he sees justifies the expansion . . . . It is not the wave of optimism that makes times good. Good times are almost bound to bring a wave of optimism with them. On the other hand, when the decline comes, it comes not because anyone loses confidence, but because the basic economic forces are changing. Once let the real support for the boom collapse, and all the optimism bred through years of prosperity will not hold the line. Typically, confidence tends to hold up after a downturn has set in.31

31V. Lewis Bassic, “Recent Developments in Short-Term Forecasting,” in
Short-Term Forecasting, Studies in Income and Wealth
(Princeton, N.J.: National Bureau of Economic Research, 1955), vol. 17, pp. 11–12. Also see pp. 20–21.

Part II

The Inflationary Boom: 1921–1929

4

The Inflationary Factors

Most writers on the 1929 depression make the same grave mistake that plagues economic studies in general—the use of historical statistics to “test” the validity of economic theory. We have tried to indicate that this is a radically defective methodology for economic science, and that theory can only be confirmed or refuted on prior grounds. Empirical fact enters into the theory, but only at the level of basic axioms and without relation to the common historical–statistical “facts” used by present-day economists. The reader will have to go elsewhere—

notably to the works of Mises, Hayek, and Robbins—for an elaboration and defense of this epistemology. Suffice it to say here that statistics can prove nothing because they reflect the operation of numerous causal forces. To “refute” the Austrian theory of the inception of the boom because interest rates might not have been lowered in a certain instance, for example, is beside the mark. It simply means that other forces—perhaps an increase in risk, perhaps expectation of rising prices—were strong enough to raise interest rates. But the Austrian analysis, of the business cycle continues to operate regardless of the effects of other forces. For the important thing is that interest rates
are lower than they would have
been without the credit expansion
. From theoretical analysis we know that this is the effect of every credit expansion by the banks; but statistically we are helpless—we cannot use statistics to estimate what the interest rate
would have been
. Statistics can only record past events; they cannot describe possible but unrealized events.

85

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Similarly, the designation of the 1920s as a period of inflationary boom may trouble those who think of inflation as a rise in prices. Prices generally remained stable and even fell slightly over the period. But we must realize that two great forces were at work on prices during the 1920s—the monetary inflation which pro-pelled prices upward and the increase in productivity which lowered costs and prices. In a purely free-market society, increasing productivity will increase the supply of goods and lower costs and prices, spreading the fruits of a higher standard of living to all consumers. But this tendency was offset by the monetary inflation which served to stabilize prices. Such stabilization was and is a goal desired by many, but it (a) prevented the fruits of a higher standard of living from being diffused as widely as it would have been in a free market; and (b) generated the boom and depression of the business cycle. For a hallmark of the inflationary boom is that prices are higher than they would have been in a free and unhampered market. Once again, statistics cannot discover the causal process at work.

If we were writing an economic history of the 1921–1933 period, our task would be to try to isolate and explain all the causal threads in the fabric of statistical and other historical events. We would analyze various prices, for example, to identify the effects of credit expansion on the one hand and of increased productivity on the other. And we would try to trace the processes of the business cycle, along with all the other changing economic forces (such as shifts in the demand for agricultural products, for new industries, etc.) that impinged on productive activity. But our task in this book is much more modest: it is to pinpoint the specifically cyclical forces at work, to show how the cycle was generated and perpetuated during the boom, and how the adjustment process was hampered and the depression thereby aggravated. Since government and its controlled banking system are wholly responsible for the boom (and thereby for generating the subsequent depression) and since government is largely responsible for aggravating the depression, we must necessarily concentrate on these acts of government intervention in the economy. An unhampered market would not generate booms and depressions, and, if confronted by a depression
The Inflationary Factors