This tendency toward a rise in the rate of originary interest and the emergence of a positive price premium explain some characteristics of the boom. The banks are faced with an increased demand for loans and advances on the part of business. The entrepreneurs are prepared to borrow money at higher gross rates of interest. They go on borrowing in spite of the fact that the banks charge more interest. Arithmetically, the gross rates of interest are rising above their height on the eve of the expansion. Nonetheless, they lag catallactically behind the height at which they would cover originary interest plus entrepreneurial component and price premium. The banks believe that they have done all that is needed to stop “unsound” speculation when they lend on more onerous terms. They think that those critics who blame them for fanning the flames of the boom-frenzy of the market are wrong. They fail to see that in injecting more and more fiduciary media into the market they are in fact kindling the boom. It is the continuous increase in the supply of the fiduciary media that produces, feeds, and accelerates the boom. The state of the gross market rates of interest is only an outgrowth of this increase. If one wants to know whether or not there is credit expansion, one must look at the state of the supply of fiduciary media, not at the arithmetical state of interest rates.
It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4 They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible. There are plants which cannot be utilized because the plants needed for the production of the complementary factors of production are lacking; plants the products of which cannot be sold because the consumers are more intent upon purchasing other goods which, however, are not produced in sufficient quantities; plants the construction of which cannot be continued and finished because it has become obvious that they will not pay.
The erroneous belief that the essential feature of the boom is overinvestment and not malinvestment is due to the habit of judging conditions merely according to what is perceptible and tangible. The observer notices only the malinvestments which are visible and fails to recognize that these establishments are malinvestments only because of the fact that other plants—those required for the production of the complementary factors of production and those required for the production of consumers' goods more urgently demanded by the public—are lacking. Technological conditions make it necessary to start an expansion of production by expanding first the size of the plants producing the goods of those orders which are farthest removed from the finished consumers' goods. In order to expand the production of shoes, clothes, motorcars, furniture, houses, one must begin with increasing the production of iron, steel, copper, and other such goods. In employing the supply of r + p1 + p2 which would suffice for the production of a + g1 + g2 as if it were r + p1 + p2 + p3 + p4 and would suffice for the production of a + g1 + g2 + g3 + g4, one must first engage in increasing the output of those products and structures which for physical reasons are first required. The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizcs the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not overinvestment, but an inappropriate employment of the means at his disposal.
It is no less erroneous to believe that the events which resulted in the crisis amounted to an undue conversion of “circulating” capital into “fixed” capital. The individual entrepreneur, when faced with the credit stringency of the crisis, is right in regretting that he has expended too much for an expansion of his plant and for the purchase of durable equipment; he would have been in a better situation if the funds used for these purposes were still at his disposal for the current conduct of business. However, raw materials, primary commodities, half-finished manufactures and foodstuffs are not lacking at the turning point at which the upswing turns into the depression. On the contrary, the crisis is precisely characterized by the fact that these goods are offered in such quantities as to make their prices drop sharply.
The foregoing statements explain why an expansion in the production facilities and the production of the heavy industries, and in the production of durable producers' goods, is the most conspicuous mark of the boom. The editors of the financial and commercial chronicles were right when—for more than a hundred years—they looked upon production figures of these industries as well as of the construction trades as an index of business fluctuations. They were only mistaken in referring to an alleged overinvestment.
Of course, the boom affects also the consumers' goods industries. They too invest more and expand their production capacity. However, the new plants and the new annexes added to the already existing plants are not always those for the products of which the demand of the public is most intense. They may well have agreed with the whole plan aiming at the production of r + g1 + g2 + g3 + g4 The failure of this oversized plan discloses their inappropriateness.
A sharp rise in commodity prices is not always an attending phenomenon of the boom. The increase of the quantity of fiduciary media certainly always has the potential effect of making prices rise. But it may happen that at the same time forces operating in the opposite direction are strong enough to keep the rise in prices within narrow limits or even to remove it entirely. The historical period in which the smooth working of the market economy was again and again interrupted through expansionist ventures was an epoch of continuous economic progress. The steady advance in the accumulation of new capital made technological improvement possible. Output per unit of input was increased and business filled the markets with increasing quantities of cheap goods. If the synchronous increase in the supply of money (in the broader sense) had been less plentiful than it really was, a tendency toward a drop in the prices of all commodities would have taken effect. As an actual historical event credit expansion was always embedded in an environment in which powerful factors were counteracting its tendency to raise prices. As a rule the resultant of the clash of opposite forces was a preponderance of those producing a rise in prices. But there were some exceptional instances too in which the upward movement of prices was only slight. The most remarkable example was provided by the American boom of 1926–29.
The essential features of a credit expansion are not affected by such a particular constellation of the market data. What induces an entrepreneur to embark upon definite projects is neither high prices nor low prices as such, but a discrepancy between the costs of production, inclusive of interest on the capital required, and the anticipated prices of the products. A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear so before. It actuates business to employ r + p1 + P2 as if it were r + p1 + p2 + p3 + p4 It necessarily brings about a structure of investment and production activities which is at variance with the real supply of capital goods and must finally collapse. That sometimes the price changes involved are laid against a background of a general tendency toward a rise in purchasing power and do not convert this tendency in
to its manifest opposite but only into something which may by and large be called price stability, modifies merely some accessories of the process.
However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The boom is built on the sands of banknotes and deposits. It must collapse.
The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further expansion of credit. The boom could continue only as long as the banks were ready to grant freely all those credits which business needed for the execution of its excessive projects, utterly disagreeing with the real state of the supply of factors of production and the valuations of the consumers. These illusory plans, suggested by the falsification of business calculation as brought about by the cheap money policy, can be pushed forward only if new credits can be obtained at gross market rates which are artificially lowered below the height they would reach at an unhampered loan market. It is this margin that gives them the deceptive appearance of profitability. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.
Neither could the boom last endlessly if the banks were to cling stubbornly to their expansionist policies. Any attempt to substitute additional fiduciary media for nonexisting capital goods (namely, the quantities p3 and p4.) is doomed to failure. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. However, as a rule, the banks in the past have not pushed things to extremes. They have become alarmed at a date when the final catastrophe was still far away.7
As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap. Factories are closed, the continuation of construction projects in progress is halted, workers are discharged. As on the one hand many firms badly need money in order to avoid bankruptcy, and on the other hand no firm any longer enjoys confidence, the entrepreneurial component in the gross market rate of interest jumps to an excessive height.
Accidental institutional and psychological circumstances generally turn the outbreak of the crisis into a panic. The description of these awful events can be left to the historians. It is not the task of catallactic theory to depict in detail the calamities of panicky days and weeks and to dwell upon their sometimes grotesque aspects. Economics is not interested in what is accidental and conditioned by the individual historical circumstances of each instance. Its aim is, on the contrary, to distinguish what is essential and apodictically necessary from what is merely adventitious. It is not interested in the psychological aspects of the panic, but only in the fact that a credit-expansion boom must unavoidably lead to a process which everyday speech calls the depression. It must realize that the depression is in fact the process of readjustment, of putting production activities anew in agreement with the given state of the market data: the available supply of factors of production, the valuations of the consumers, and particularly also the state of originary interest as manifested in the public's valuations.
These data, however, are no longer identical with those that prevailed on the eve of the expansionist process. A good many things have changed. Forced saving and, to an even greater extent, regular voluntary saving may have provided new capital goods which were not totally squandered through malinvestment and overconsumption as induced by the boom. Changes in the wealth and income of various individuals and groups of individuals have been brought about by the unevenness inherent in every inflationary movement. Apart from any causal relation to the credit expansion, population may have changed with regard to figures and the characteristics of the individuals comprising them; technological knowledge may have advanced, demand for certain goods may have been altered. The final state to the establishment of which the market tends is no longer the same toward which it tended before the disturbances created by the credit expansion.
Some of the investments made in the boom period appear, when appraised with the sober judgment of the readjustment period, no longer dimmed by the illusions of the upswing, as absolutely hopeless failures. They must simply be abandoned because the current means required for their further exploitation cannot be recovered in selling their products; this “circulating” capital is more urgently needed in other branches of want-satisfaction; the proof is that it can be employed in a more profitable way in other fields. Other malinvestments offer somewhat more favorable chances. It is, of course, true that one would not have embarked upon putting capital goods into them if one had correctly calculated. The inconvertible investments made on their behalf are certainly wasted. But as they are inconvertible, a fait accompli, they present further action with a new problem. If the proceeds which the sale of their products promises are expected to exceed the costs of current operation, it is profitable to carry on. Although the prices which the buying public is prepared to allow for their products are not high enough to make the whole of the inconvertible investment profitable, they are sufficient to make a fraction, however small, of the investment profitable. The rest of the investment must be considered as expenditure without any offset, as capital squandered and lost.
If one looks at this outcome from the point of view of the consumers, the result is, of course, the same. The consumers would be better off if the illusions created by the easy-money policy had not enticed the entrepreneurs to waste scarce capital goods by investing them for the satisfaction of less urgent needs and withholding them from lines of production in which they would have satisfied more urgent needs. But as things are now, they cannot but put up with what is irrevocable. They must for the time being renounce certain amenities which they could have enjoyed if the boom had not engendered malinvestment. But, on the other hand, they can find partial compensation in the fact that some enjoyments are now available to them which would have been beyond their reach if the smooth course of economic activities had not been disturbed by the orgies of the boom. It is slight compensation only, as their demand for those other things which they do not get because of inappropriate employment of capital goods is more intense than their demand for these “substitutes,” as it were. But it is the only choice left to them as conditions and data are now.
The final outcome of the credit expansion is general impoverishment. Some people may have increased their wealth; they did not let their reasoning be obfuscated by the mass hysteria, and took advantage in time of the opportunities offered by the mobility of the individual investor. Other individuals and groups of individuals may have been favored, without any initiative of their own, by the mere time lag between the rise in the prices of the goods they sell and those they buy. But the immense majority must foot the bill for the malinvestments and the overconsumption of the boom episode.
One must guard oneself against a misinterpretation of this term impoverishment. It does not mean impoverishment when compared with the conditions that prevailed on the eve of the credit expansion. Whether or not an impoverishment in this sense takes place depends on the particular data of each case; it cannot be predicated apodictically by catallactics. What catallactics has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom. The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living. The pace of this progress is so rapid that, in the course of a bo
om period, it may well outstrip the synchronous losses caused by malinvestment and overconsumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still better state of satisfaction.
The Alleged Absence of Depressions Under Totalitarian Management
Many socialist authors emphasize that the recurrence of economic crises and business depressions is a phenomenon inherent in the capitalist mode of production. On the other hand, a socialist system is safe against this evil.
As has already become obvious and will be shown later again, the cyclical fluctuations of business are not an occurrence originating in the sphere of the unhampered market, but a product of government interference with business conditions designed to lower the rate of interest below the height at which the free market would have fixed it.8 At this point we have only to deal with the alleged stability as secured by socialist planning.
It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by the entrepreneurs. They manifest their disapprobation by their conduct in buying and abstention from buying. The entrepreneurs, misled by the illusions of the artificially lowered gross market rate of interest, have failed to invest in those lines in which the most urgent needs of the public would have been satisfied in the best possible way. As soon as the credit expansion comes to an end, these faults become manifest. The attitudes of the consumers force the businessmen to adjust their activities anew to the best possible want-satisfaction. It is this process of liquidation of the faults committed in the boom and of readjustment to the wishes of the consumers which is called the depression.
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