# The Economics of Unemployment/Chapter 4

CHAPTER IV
THE PSYCHOLOGY OF TRADE FLUCTUATIONS
Men's actions are so dependent upon changes in their beliefs and feelings that economists and business men are often led to use language implying that industrial prosperity and depression are little else than reflections of a rhythmic movement of confidence and dejection in the minds of men. This psychological rhythm operating through Credit, the financial index of confidence, they regard not merely as an accompaniment and agent but as the efficient cause of industrial fluctuations. Once start with the assumption that the business mind is by nature subject to these elations and depressions and that they are swiftly and easily communicated by business leaders to the rank and file, the theory of independent psychological causation becomes plausible. In a period of rising confidence business men not only apply their own resources, but borrow freely both from the investing public and from banks, in order to extend their business operations. This borrowing from banks, being the most elastic form of credit, is of the first importance. The bankers, sharing the same confidence with their customers, make large advances upon easy terms at such periods. This produces an industrial and commercial activity which later on culminates in a condition recognised ​as over-trading. As soon as this is recognised, the confidence both of bankers and of business men begins to wane, credits are restricted and drawn in because of the belief that trade is going down, and this belief and this restriction are the means of reducing the volume of trade and contracting its profits. Thus a depression is brought on "because of their unbelief."
Now it is quite evident that confidence and credit, their rise and collapse, play an important part in trade fluctuations and volume of employment. I have purposely ignored this in my previous analysis, because I desire to obtain a definite reply to two related questions. First, what is the actual part played by credit in bringing about cyclical depressions? Secondly, assuming such social reforms as we advocate for the absorption of surplus income in wages and public revenue, would the psychological waves of confidence and credit continue to produce their effects? Now, in discussing the first question, I must dismiss at the outset as illicit and unnecessary the assumption of any psychological movement independent in its origin of the industrial situation. I cannot begin by assuming a rising and waning tide of confidence wholly divorced from economic facts. Although this vague notion of a purely mental origin of business confidence often finds expression, I do not think that any able business man would maintain it under cross-examination. He would always admit that the rising or waning confidence in the business world was based on facts or supposed facts relating to movements of the markets, i.e. upon actual sales or contracts.
I think he would assent to the following account ​of a revival, growth, culmination, and decline of trade, in relation to the part played by bank credits.
When a trade depression with low production, low consumption, and low prices and profits, has gone on for some time, the excessive stocks which, congesting the markets, brought prices down, show signs of depletion, and it becomes evident that the current low production will soon be insufficient to meet the demand, and that prices are likely to recover. Merchants handling wholesale trade in the world market are naturally most sensitive to the situation, and they are usually the first to take action. In anticipation of a growing volume of sales at higher prices they make contracts with manufacturers and other producers for future delivery of materials and goods. These producing firms, desiring to replenish their depleted supplies of raw materials, fuel, etc., in preparation for a renewed activity in their mills and workshops, require money for these purposes and for other working expenses, and apply to their banks for credit, adducing the contracts they have made with merchants as evidence of a reviving trade, rising prices, and profits, and a consequent ability to meet the overdraft. The fundamental and instrumental industries, such as mining, engineering, shipbuilding, and metals, where the depression and unemployment have been deepest, must get to work first, in order to make adequate provision for the renewed activity in the later stages of production, and must similarly have recourse to bank assistance for their working expenses. For, until the output of fuel and material has been increased, ​it is not possible for the later manufacturers to get under full way. The recovery of the fundamental and instrumental trades, with the assistance of bank-made purchasing power, is quicker than would otherwise be possible, for it causes a larger proportion of the aggregate purchasing power of the community to be applied at these stages of production in the purchase of increased quantities of materials and labour at rising prices. As these increased supplies of instrumental goods flow into the later manufactures, the anticipated revival is realised there also, and growing quantities of goods, financed with bank-made money, are supplied to merchants in fulfilment of contracts at prices which continue to rise and enable good profits to be made. Merchants, having thus made provision for increasing stocks to meet an anticipated recovery of effective demand for commodities on the part of the consuming public, take their toll in the reviving trade, straining their credit in order to enable them to do the largest amount of it.
Now the part thus played by confidence and credit is manifest. They have brought into play an increased quantity of purchasing power, and, by directing it to the stimulation of the different processes of industry in proper order, have swelled the great stream of employment and production, turning out increased supplies of goods to meet an increase of effective demand coming from consumers, whose incomes, derived from rising profit and wages, have risen by the time the trade revival has put increased supplies into the retail shops and who can therefore afford to raise their consumption. Thus put, it may appear ​as if the mere manufacture of bank credit performed a faith-cure. But closer reflection dispels this notion. For this bank credit is based upon and limited by considerations of concrete industrial fact. The merchants and financiers, 'whose skilled prevision sets the ball a-rolling,' are not mere gamblers. They see that the trade depression is nearly worked out, in the sense that the congested stocks held by manufacturers and speculators have been almost entirely unloaded, and that the actual available supplies are becoming insufficient to meet what may be termed the current irreducible demand. In a word, the waste of the stoppage has gone on so far as to exhibit a temporary condition of general under-production. Recognising that the rate of effective supply has fallen below the minimum effective demand, and that prices must rise, they set in train, as we see, a series of industrial activities, by means of increased credits. These increased credits express and measure the belief of bankers in the renewal of industrial activity. But their belief is based upon the actual evidence of reviving trade furnished to them by their customers, and it is on the strength of this that they extend banking facilities.
The limits set on such extension depend upon two conditions: first, the conviction of bankers that trade will continue on the up-grade with rising prices and profits; second, the quantity of cash at their command in relation to the quantity of credit advances they have made. These two conditions are not entirely separate. When confidence in trade prosperity is strong, banks will be freer with credit facilities than ​when confidence is weak. But even in times of high confidence the extension of credits to reliable customers must keep some relation to available cash reserves.
The last consideration plays a critical part in the cycle of industrial activity. For after a period of trade expansion with rising prices and good profits has gone on for some time, the keen classes of general business men, merchants and bankers, etc., recognise that the upward movement cannot continue much longer, and that a conservative policy requires the curtailment of orders for future delivery, with the corresponding reactions upon production and employment. But why, it may be asked, should merchants come to this conclusion? What is the meaning of the upward movement 'having run its course'? What happens is not an irrational collapse of confidence. When trade activity has reached a certain height, the difficulty of finding a remunerative market for all the product at current or even lower prices becomes apparent. In other words, markets are visibly over-stocked and the capacity exists to go on over-stocking them. It is the knowledge of these facts that makes the merchant draw in his orders and the banker his credits.
If bankers have been over sanguine in their estimates of the strength and duration of the boom, they may close down with such promptitude as to bring about a financial and commercial crisis. This applies particularly to countries where, as in Germany and America, the bank financing of industry and commerce has been most fully developed, and where credit ​facilities are apt to be unduly strained. But everywhere the recognition of the signs of declining trade will induce bankers to try to call in credits and stiffen their terms for further advances. This policy, however judiciously applied, means a cramping of industry and a fall of prices, first in the region of raw materials and afterwards of commodities. If sharply applied, this curtailing of credit may precipitate a crisis, forcing holders of stocks of goods purchased at high prices to realise upon a falling market whose fall is quickened by this very process, and spreading bankruptcy and ruin far and wide. Cautiously applied, it substitutes a longer, slower process of price-fall and depression, leaving large quantities of frozen credits to be liquidated by a gradual marketing of the frozen goods which are the economic counterparts, and which, if the process be sufficiently prolonged, may realise prices not so ruinously low as would be the case if sharper action had been taken by the banks. It is interesting to observe that criticism of the banks generally turns upon the related charges, viz. that they are too lax in checking the over-confidence and over-trading of their customers in the high reaches of a boom, and too stringent in their refusal of credits to support trade when prices begin to fall and a slump appears on the horizon. So far as this criticism is valid, it implies that bankers who ought to know better, share and even encourage by their easy credits in times of good trade the excessive confidence of their customers that prices and volume of trade will go on rising, or at any rate will stand firm on a high level, and that, when this faith is falsified by trade ​shrinkage and falling prices, they share in an excessive degree the fears of their customers and help to realise those fears by a credit policy of excessive stringency. So, it is suggested, the finance policy of banks is largely responsible for the excessive activity of trade and the height of the rise of prices in a boom, and for the excessive slackness and fall of prices in a slump. Their excesses alike in expansion and contraction of credit are held responsible for the actual movements of industry.
But such criticism imputes too much responsibility to expansions and contractions of credit as efficient causes of industrial changes. The language often used suggests that a trade boom and the credit policy supplying it are in themselves an economic movement that involves by some natural necessity a corresponding trade slump. In other words, the cyclical fluctuation is regarded as a law of industrial life in the same sense as the rhythmic movement of respiration in the body or of the seasons in the year, the operation of the credit system serving to exaggerate its inevitable ​and even salutary action. It is held to belong to the give and take, the elasticity of an economic system which requires periods of expansion and contraction as factors in a healthy life.
Finance, thus envisaged through its skilled manipulation of monetary power, principally credit, regulates industrial life, stimulating this trade or class of investment and checking another, so as to employ to the highest net advantage of economic society (and by some natural chain of coincidence the highest profits of financiers) the available forces of production. The economy of use of this stimulus, a sort of nervous energy, involves not merely its proper distribution as between trade and trade, country and country, but this periodicity of high and low functioning as a whole which comes out in high activity and depression. So the conception of cyclical fluctuation, found in actual industry, is fathered on to finance, and it is held that these financial fluctuations are similarly natural and inevitable.
How far is this assumption of the necessity of rhythmic fluctuations a mere begging of the question? One sees that they do happen and argues that they must. And, doubtless, other things unchanged, they must. But here we come once more to grips with our problem.
There is no ground for imputing any independent causation to credit as a factor in trade fluctuations. Its operation only quickens, exaggerates, and facilitates industrial changes that are otherwise produced. When after a depression trade revives, that revival, as we see, is immediately due to the recognition that ​current low production is insufficient to meet an early, expected, effective demand at the existing level of prices. Credit operates to stimulate the rate of production by putting an increased quantity of existing but idle producing power into the hands of business men, who will apply it in causing more productive energy to function in the fundamental and instrumental industries. It acts, in other words, as the instrument for correcting a condition of under-production, by throwing a quantity of unemployed labour and plant into the supply of increasing quantities of raw materials and other capital goods.
This is in effect a stimulation of saving. For a larger proportion of the increased volume of purchasing power thus created is applied to pay for the production of more capital goods, and a smaller proportion is applied to the purchase of final commodities for consumption. While, then, during the depression the proportion of saving to spending was kept abnormally low, so as to let out the previous accumulations of unmarketable goods, the revival of trade is initiated by financial measures which force more saving and so reinvigorate the productive processes.
Since the use of the new credits involves increased employment of labour and a larger aggregate wage-bill, a good deal of the enlarged volume of purchasing power will soon begin to operate at the other end of industry in a growing demand for consumable commodities. But the early normal effect of a trade revival through expanding credit will be a rise of prices and an enlarged sale of materials and ​semi-manufactured goods, on terms of high profits. Though more employment will give higher aggregate wages, wage-rates will not rise so fast as prices and profits. This wage-lag is generally admitted. It signifies for us the important fact that during rising prices and reviving trade the distribution of the product, i.e. of real incomes, is favourable to the employing and capitalist classes, unfavourable to labour. For though the wages and even the real income of the workers may be rising with the enlargement of the product, this enhanced working-class income represents a smaller proportion of the whole income. Now since saving, as we see, comes mainly from the accumulation of surplus income of the capitalist and employing classes, the under-saving which accompanied depression now gives place to what will once more become over-saving when the revival of trade has gone some distance. For as the process of revival with rising prices goes on, the amount of fresh credit needed to finance the expanding volume of business on a higher price level continually grows, and since the time-lag for wages still keeps trade highly profitable, the increased saving and the increasing production continues, making once more towards a rate of production visibly greater than is able to find a profitable market So a check upon the rise of prices takes place, the lag of wages has time to catch up, and employers are faced with high costs of production when prices are beginning to fall and markets are insecure. Under such circumstances finance begins to take alarm and credits are restricted, and so the downward path once more is taken.
​Now what I wish to ask is in what sense this fluctuation, thus induced, can be regarded rightly as inevitable, inherent in the nature of industry. Given a tardy recovery brought about in the way here described, making towards a condition of full employment of the available factors of production, capital and labour, is there any reason why the full employment at high prices, with high profits and high wages, should not continue indefinitely? Only one, viz. a failure to sell at the current high prices the whole supply of final commodities which the whole process of production is capable of putting into the markets. Now it is admitted that all these final commodities could be sold, in the sense that some one possesses the money income capable of buying them, i.e. they belong to someone who can either consume them or exchange them for other consumables which he prefers. But the fact remains that they cannot find a sufficient number of buyers and consumers, and, therefore, being left unbought, congest the markets and bring down prices, and even at these lower prices cannot get a full market. This congestion operates at once to slow down all the processes of production, and so the world gets once more into a depression.
Now we have noted one significant fact in the process of trade revival which may explain the apparent necessity of over-production and collapse That is the admitted lag of wages. This lag continues throughout the upward process, when with expanding credit and production prices and profits rise. Only when ​the rise of prices has already stopped for some time do wages catch up, and high wages are then held responsible for the failure to market goods at profitable prices.
Now, suppose that by some economic arrangement it were possible to do away with the lag of wages, so that wage rates rose automatically and proportionately with rises of prices and of profits. Is it not evident, that we should have an important correction of fluctuations? It would operate in two ways, first in reducing the rate of profits and so the rate of saving and of increased production, secondly, in stimulating the rate of consumption. In other words, it would make for an adjustment between the rate of reviving production and of reviving consumption which might maintain an equilibrium between the two processes at a high level for an indefinite time, avoiding the slump otherwise held to be inevitable. The expansion of production and employment would, as before, continue until all the factors of production were in full use, but this process would go more slowly because a smaller proportion of the income would be available for saving, i.e. for making capital goods. But, assuming that the adjustment between wages and profits were such as to keep an economically sound proportion between growth of production and of consumption, there seems no reason why the high level of trade, prices, and employment, once restored, should not be maintained.
The removal of the wage-lag would also act in another way on credit and prices. By curbing the high profits, which the wage-lag renders possible, it would reduce ​the incentive of business men to borrow and of bankers to lend. So less credit would be manufactured, prices would not rise as much or as fast, and the whole process of reviving trade would take place more slowly. This slower recovery would be the price paid for the greater security of the recovered trade. The removal of the wage-lag would thus certainly reduce the fluctuation, by making the recovery of trade more gradual and preventing the level of prices rising so high. As soon as production and employment attained their full dimensions, the tendency to congestion of markets would be checked by the existence of a larger demand for commodities on the part of labour. So, even supposing that the adjustment between production and consumption were not kept true by the removal of the wage-lag, and a glut of goods took place, followed by a decline of trade and of employment, that glut would be smaller and the depression would be shallower.
* ↑ Cf. Hawtrey, Currency and Credit.
* ↑ Senator Glass puts the matter incisively in his elaborate defence of the Federal Reserve System in the United States Senate, January 16-17, 1922: "The truth in one sentence is that falling prices caused the deflation of credits and currency, such as we have witnessed since January of last year, and not deflation of credits the fall of prices." Falling prices he attributes to failure of demand. "Building was reduced to a minimum, road construction was stopped, furnaces from one end of the country to the other were banked, unemployment to a frightful extent ensued; and all this for no lack of credit facilities, but for lack of markets in which to sell the products of farm and mill and factory." He adds the interesting comment: "Had the banks of the country contracted loans just before the drop in prices, instead of lavishly extending loans, thousands of people who are now in distress would be happy and content."
* ↑ We discuss later the theory of Major Douglas, which involves a denial of this assumption.