Mitchell's Theory of Business Cycles
[244]Only by putting any theory to the practical test of accounting for actual business experience can its value be determined. The case for the present theory, therefore, and also the case against it, is to be found not in the easy summary which follows, but in the difficult chapters which precede,[245] or better still in an independent effort to use it in interpreting the ceaseless ebb and flow of economic activity.
1. THE CUMULATION OF PROSPERITY
With whatever phase of the business cycle analysis begins, it must take for granted the conditions brought about by the preceding phase, postponing explanation of these assumptions until it has worked around the cycle and come again to its starting point.
A revival of activity, then, starts with this legacy from depression: a level of prices low in comparison with the prices of prosperity, drastic reductions in the costs of doing business, narrow margins of profit, liberal bank reserves, a conservative policy in capitalizing business enterprises and in granting credits, moderate stocks of goods, and cautious buying.
For reasons which will appear in the sequel, such conditions are accompanied by an expansion in the physical volume of trade. Though slow at first, this expansion is cumulative. Now it is only a question of time when an increase in the amount of business transacted which grows more rapid as it proceeds will turn dullness into activity. Left to itself, this transformation is effected by slow degrees; but it is often hastened by some propitious event arising from other than domestic business sources, such as exceptionally profitable harvests, heavy purchases of supplies by Government, or a marked increase in the export demand for the products of home industry.
Even when a revival of activity is confined at first within a narrow range of industries or within some single section of the country, it soon spreads to other parts of the business field. For the active enterprises must buy more materials, wares, and current supplies from other enterprises, the latter from still others, and so on without assignable limits. Meanwhile all enterprises which become busier employ more labor, use more borrowed money, and make higher profits. There results an increase in family incomes and an expansion of consumers' demand, which likewise spreads out in ever widening circles. Shopkeepers pass on larger orders for consumers' goods to wholesale merchants, manufacturers, importers, and producers of raw materials. All these enterprises require more supplies of various kinds for handling their growing trade, and increase the sums which they pay out to employés, lenders, and proprietors—thus stimulating afresh the demand for both producers' and consumers' goods. Soon or late this expansion of orders reaches back to the enterprises from which the impetus to greater activity was first received, and then this whole complicated series of reactions begins afresh at a higher pitch of intensity. All this while, the revival of activity is instilling a feeling of optimism among business men, and this feeling both justifies itself and heightens the forces which engendered it by making every one readier to buy with freedom.
While the price level is often sagging slowly when a revival begins, the cumulative expansion in the physical volume of trade presently stops the fall and starts a rise. For, when enterprises have in sight as much business as they can handle with their existing facilities of standard efficiency, they stand out for higher prices on additional orders. This policy prevails even in the most keenly competitive trades, because additional orders can be executed only by breaking in new hands, starting old machinery, buying new equipment, or making some other change which involves increased expense. The expectation of its coming hastens the advance. Buyers are anxious to secure or to contract for large supplies while the low level of quotations continues, and the first definite signs of an upward trend of quotations brings out a sudden rush of orders.
Like the increase in the physical volume of business, the rise of prices spreads rapidly; for every advance of quotations puts pressure upon some one to recoup himself by making a compensatory advance in the prices of what he has to sell. The resulting changes in prices are far from even, not only as between different commodities, but also as between different parts of the system of prices. Retail prices lag behind wholesale, the prices of staple consumers' behind the prices of staple producers' goods, and the prices of finished products behind the prices of their raw materials. Among raw materials, the prices of mineral products reflect the changed business conditions more regularly than do the prices of raw animal, farm, or forest products. Wages rise often more promptly, but always in less degree than wholesale prices; discount rates rise sometimes more slowly than commodities and sometimes more rapidly; interest rates on long loans always more sluggishly in the early stages of revival, while the prices of stocks—particularly of common stocks—both precede and exceed commodity prices on the rise. The causes of these differences in the promptness and the energy with which various classes of prices respond to the stimulus of business activity are found partly in differences of organization between the markets for commodities, labor, loans, and securities; partly in the technical circumstances affecting the relative demand for and supply of these several classes of goods; and partly in the adjusting of selling prices to changes in the aggregate of buying prices which a business enterprise pays, rather than to changes in the prices of the particular goods bought for resale.
In the great majority of enterprises, larger profits result from these divergent price fluctuations coupled with the greater physical volume of sales. For, while the prices of raw materials and of wares bought for resale usually, and the prices of bank loans often, rise faster than selling prices, the prices of labor lag far behind, and the prices which make up supplementary costs, i. e., interest, rent, depreciation, insurance, salaries for general officials and the like, are mainly stereotyped for a time by old agreements regarding salaries, leases, and bonds.
This increase of profits, combined with the prevalence of business optimism, leads to a marked expansion of investments. Of course the heavy orders for machinery, the large contracts for new construction, etc., which result, swell still further the physical volume of business, and render yet stronger the forces which are driving prices upward.
Indeed, the salient characteristic of this phase of the business cycle is the cumulative working of the various processes which are converting a revival of trade into intense prosperity. Not only does every increase in the physical volume of trade cause other increases, every convert to optimism makes new converts, and every advance of prices furnishes an incentive for fresh advances; but the growth of trade also helps to spread optimism and to raise prices, while optimism and rising prices both support each other and stimulate the growth of trade. Finally, as has just been said, the changes going forward in these three factors swell profits and encourage investments, while high profits and heavy investments react by augmenting trade, justifying optimism, and raising prices.
2. HOW PROSPERITY BREEDS A CRISIS
While the processes just sketched work cumulatively for a time to enhance prosperity, they also cause a slow accumulation of stresses within the balanced system of business—stresses which ultimately undermine the conditions upon which prosperity rests.
Among these stresses is the gradual increase in the costs of doing business. The decline in supplementary costs per unit of output ceases when enterprises have once secured all the business they can handle with their standard equipment, and a slow increase of these costs begins when the expiration of old contracts makes necessary renewals at the high rates of interest, rent, and salaries which prevail in prosperity. Meanwhile prime costs, wages and raw materials, rise at a relatively rapid rate. Equipment which is antiquated and plants which are ill located or otherwise work at some disadvantage are brought again into operation. The price of labor rises, not only because standard rates of wages go up, but also because of the prevalence of higher pay for overtime. More serious still is the fact that the efficiency of labor declines, because overtime brings weariness, because of the employment of "undesirables," and because crews cannot be driven at top speed when jobs are more numerous than men to fill them. The prices of raw materials continue to rise faster on the average than the selling prices of products. Finally, the numerous small wastes, incident to the conduct of business enterprises, creep up when managers are hurried by a press of orders demanding prompt delivery.
A second stress is the accumulating tension of the investment and money markets. The supply of funds available at the old rates of interest for the purchase of bonds, for lending on mortgages, and the like, fails to keep pace with the rapidly swelling demand. It becomes difficult to negotiate new issues of securities except on onerous terms, and men of affairs complain of the "scarcity of capital." Nor does the supply of bank loans grow fast enough to keep up with the demand. For the supply is limited by the reserves which bankers hold against their expanding demand liabilities. Full employment and active retail trade cause such a large amount of money to remain suspended in active circulation that the cash left in the banks increases rather slowly, even when the gold output is rising most rapidly. On the other hand, the demand for bank loans grows not only with the physical volume of trade, but also with the rise of prices, and with the desire of men of affairs to use their own funds for controlling as many business ventures as possible. Moreover, this demand is relatively inelastic, since many borrowers think they can pay high rates of discount for a few months and still make profits on their turnover, and since the corporations which are unwilling to sell long-time bonds at the hard terms which have come to prevail try to raise part of the funds they require by discounting one- or two-year notes.
Tension in the bond and money markets is unfavorable to the continuance of prosperity, not only because high rates of interest reduce the prospective margins of profit, but also because they check the expansion in the volume of trade out of which prosperity developed. Many projected ventures are relinquished or postponed, either because borrowers conclude that the interest would absorb too much of their profits, or because lenders refuse to extend their commitments farther.
There is one important group of enterprises which suffers an especially severe check from this cause in conjunction with high prices—the group which depends primarily upon the demand for industrial equipment. In the earlier stages of prosperity, this group usually enjoys a season of exceptionally intense activity. But when the market for bonds becomes stringent, and—what is often more important—when the cost of construction has become high, business enterprises and individual capitalists alike defer the execution of many plans for extending old and erecting new plants. As a result, contracts for this kind of work become less numerous as the climax of prosperity approaches. Then the steel mills, foundries, machine factories, copper smelters, quarries, lumber mills, cement plants, construction companies, general contractors, and the like find their orders for future delivery falling off. While for the present they may be working at high pressure to complete old contracts within the stipulated time, they face a serious restriction of trade in the near future.
The imposing fabric of prosperity is built with a liberal factor of safety: but the larger grows the structure the more severe become these internal stresses. The only effective means of preventing disaster while continuing to build is to raise selling prices time after time high enough to offset the encroachments of costs upon profits, to cancel the advancing rates of interest, and to keep investors willing to contract for fresh industrial equipment.
But it is impossible to keep selling prices rising for an indefinite time. In default of other checks, the inadequacy of cash reserves would ultimately compel the banks to refuse a further expansion of loans upon any terms. But before this stage has been reached, the rise of prices is stopped by the consequences of its own inevitable inequalities. These inequalities become more glaring the higher the general level is forced; after a time they threaten serious reduction of profits to certain business enterprises, and the troubles of these victims dissolve that confidence in the security of credits with which the whole towering structure of prosperity has been cemented.
What, then, are the lines of business in which selling prices cannot be raised sufficiently to prevent a reduction of profits? There are certain lines in which selling prices are stereotyped by law, by public commissions, by contracts of long term, by custom, or by business policy, and in which no advance, or but meagre advances can be made. There are other lines in which prices are always subject to the incalculable chances of the harvests, and in which the market value of all accumulated stocks of materials and finished goods wavers with the crop reports. There are always some lines in which the recent construction of new equipment has increased the capacity for production faster than the demand for their wares has expanded under the repressing influence of the high prices which must be charged to prevent a reduction of profits. The unwillingness of investors to let fresh contracts threatens loss not only to contracting firms of all sorts, but also to all the enterprises from whom they buy materials and supplies. The high rates of interest not only check the current demand for wares of various kinds, but also clog the effort to maintain prices by keeping large stocks of goods off the market until they can be sold to better advantage. Finally, the very success of other enterprises in raising selling prices fast enough to defend their profits aggravates the difficulties of the men who are in trouble. For to the latter every further rise of prices for products which they buy means a further strain upon their already stretched resources.
As prosperity approaches its height, then, a sharp contrast develops between the business prospects of different enterprises. Many, probably the majority, are making more money than at any previous stage of the business cycle. But an important minority, at least, face the prospect of declining profits. The more intense prosperity becomes, the larger grows this threatened group. It is only a question of time when these conditions, bred by prosperity, will force some radical readjustment.
Now such a decline of profits threatens worse consequences than the failure to realize expected dividends. For it arouses doubt concerning the security of outstanding credits. Business credit is based primarily upon the capitalized value of present and prospective profits, and the volume of credits outstanding at the zenith of prosperity is adjusted to the great expectations which prevail when the volume of trade is enormous, when prices are high, and when men of affairs are optimistic. The rise of interest rates has already narrowed the margins of security behind credits by reducing the capitalized value of given profits. When profits themselves begin to waver the case becomes worse. Cautious creditors fear lest the shrinkage in the market rating of the business enterprises which owe them money will leave no adequate security for repayment. Hence they begin to refuse renewals of old loans to the enterprises which cannot stave off a decline of profits, and to press for a settlement of outstanding accounts.
Thus prosperity ultimately brings on conditions which start a liquidation of the huge credits which it has piled up. And in the course of this liquidation prosperity merges into crisis.
3. CRISES AND PANICS
Once begun, the process of liquidation extends rapidly, partly because most enterprises which are called upon to settle their maturing obligations in turn put similar pressure upon their own debtors, and partly because, despite all efforts to keep secret what is going forward, news presently leaks out and other creditors take alarm.
While this financial readjustment is under way, the problem of making profits on current transactions is subordinated to the more vital problem of maintaining solvency. Business managers concentrate their energies upon providing for their outstanding liabilities and upon nursing their financial resources, instead of upon pushing their sales. In consequence, the volume of new orders falls off rapidly. That is, the factors which were already dimming the prospects of profits in certain lines of business are reinforced and extended. Even when the overwhelming majority of enterprises meet the demand for payment with success, the tenor of business developments therefore undergoes a change. Expansion gives place to contraction, though without a violent wrench. Discount rates rise higher than usual, securities and commodities fall in price, and as old orders are completed working forces are reduced; but there is no epidemic of bankruptcies, no run upon banks, and no spasmodic interruption of the ordinary business processes.
At the opposite extreme from crises of this mild order stand the crises which degenerate into panics. When the process of liquidation reaches a weak link in the chain of interlocking credits and the bankruptcy of some conspicuous enterprise spreads unreasoning alarm among the business public, then the banks are suddenly forced to meet a double strain—a sharp increase in the demand for loans, and a sharp increase in the demand for repayment of deposits. If the banks prove able to honor both demands without flinching, the alarm quickly subsides. But if, as has happened twice in America since 1890, many solvent business men are refused accommodation at any price, and if depositors are refused payment in full, the alarm turns into panic. A restriction of payments by the banks gives rise to a premium upon currency, to hoarding of cash, and to the use of various unlawful substitutes for money. A refusal by the banks to expand their loans, still more a policy of contraction, sends interest rates up to three or four times their usual figures, and causes forced suspensions and bankruptcies. There follow appeals to the Government for extraordinary aid, frantic efforts to import gold, the issue of clearing-house loan certificates, and an increase of bank-note circulation as rapid as the existing system permits. Collections fall into arrears, domestic-exchange rates are dislocated, workmen are discharged because employers cannot get money for pay-rolls or fear lest they cannot get pay for goods when delivered, stocks fall to extremely low levels, even the best bonds decline somewhat in price, commodity markets are disorganized by sacrifice sales, and the volume of business is violently contracted.
That crises still degenerate on occasion into panics in America, but not in England, France, or Germany, arises primarily from differences in banking organization and practice. In each of the three European countries, the banking system as a whole is so organized by the prevalence of branch banking and the existence of a central bank that reserves which bear a small proportion to the aggregate demand liabilities of all the offices can be applied when and where they are most needed. The central bank not only carries a reserve which is far in excess of immediate requirements in ordinary times, but also uses this reserve boldly in times of stress, presenting in both these respects a marked contrast to the policy of American banks. As a result, European business men need not fear either a refusal to lend or a restriction of payments by the banks on which they depend. And panic has small chance to develop where the depositor can get his money at need and the solvent business man can borrow. [Written before the establishment of the Federal Reserve system.]
4. DEPRESSION
The close of a panic is usually followed by the reopening of numerous enterprises which had been shut during the weeks of severest pressure. But this prompt revival of activity is partial and short-lived. It is based chiefly upon the finishing of orders received but not completely executed in the preceding period of prosperity, or upon the effort to work up and market large stocks of materials already on hand or contracted for. It comes to an end as this work is gradually finished, because new orders are not forthcoming in sufficient volume to keep the mills and factories busy.
There follows a period during which depression spreads over the whole field of business and grows more severe. Consumers' demand declines in consequence of wholesale discharges of wage-earners, the gradual exhaustion of past savings, and the reduction of other classes of family incomes. With consumers' demand falls the business demand for raw materials, current supplies, and equipment used in making consumers' goods. Still more severe is the shrinkage of investors' demand for construction work of all kinds, since few individuals or enterprises care to sink money in new business ventures so long as trade remains depressed and the price level is declining. The contraction in the physical volume of business which results from these several shrinkages in demand is cumulative, since every reduction of employment causes a reduction of consumers' demand, and every decline in consumers' demand depresses current business demand and discourages investment, thereby causing further discharges of employés and reducing consumers' demand once more.
With the contraction in the physical volume of trade goes a fall of prices. For, when current orders are insufficient to employ the existing equipment for production, competition for what business is to be had becomes keener. This decline spreads through the regular commercial channels which connect one enterprise with another, and is cumulative, since every reduction in price facilitates, if it does not force, reductions in other prices, and the latter reductions react in their turn to cause fresh reductions at the starting point.
As the rise of prices which accompanied revival, so the fall which accompanies depression is characterized by certain regularly recurring differences in degree. Wholesale prices fall faster than retail, the prices of producers' goods faster than those of consumers' goods, and the prices of raw materials faster than those of manufactured products. The prices of raw mineral products follow a more regular course than those of raw forest, farm, or animal products. As compared with general index numbers of commodity prices at wholesale, index numbers of wages and interest on long-time loans decline in less degree, while index numbers of discount rates and of stocks decline in greater degree. The only important group of prices to rise in the face of depression is that of high-grade bonds.
Of course the contraction in the physical volume of trade and the fall of prices reduce the margin of present and prospective profits, spread discouragement among business men, and check enterprise. But they also set in motion certain processes of readjustment by which depression is gradually overcome.
The prime costs of doing business are reduced by the rapid fall in the prices of raw materials and of bank loans, by the marked increase in the efficiency of labor which comes when employment is scarce and men are anxious to hold their jobs, and by close economy on the part of managers. Supplementary costs also are reduced by reorganizing enterprises which have actually become or which threaten to become insolvent, by the sale of other enterprises at low figures, by reduction of rentals and refunding of loans, by charging off bad debts and writing down depreciated properties, and by admitting that a recapitalization of business enterprises—corresponding to the lower prices of stocks—has been effected on the basis of lower profits.
While these reductions in costs are still being made, the demand for goods ceases to shrink and then begins slowly to expand—a change which usually comes in the second or third year of depression. Accumulated stocks left over from prosperity are gradually exhausted, and current consumption requires current production. Clothing, furniture, machinery and other moderately durable articles which have been used as long as possible are finally discarded and replaced. Population continues to increase at a fairly uniform rate: the new mouths must be fed and the new backs clothed. New tastes appear among consumers and new methods among producers, giving rise to demand for novel products. Most important of all, the investment demand for industrial equipment revives; for though saving may slacken it does not cease, with the cessation of foreclosure sales and corporate reorganizations the opportunities to buy into old enterprises at bargain prices become fewer, capitalists become less timid as the crisis recedes into the past, the low rates of interest on long-term bonds encourage borrowing, the accumulated technical improvements of several years may be utilized, and contracts can be let on most favorable conditions as to cost and prompt execution.
Once these various forces have set the physical volume of trade to expanding again, the increase proves cumulative, though for a time the pace of growth is kept slow by the continued sagging of prices. But while the latter maintains the pressure upon business men and prevents the increased volume of orders from producing a rapid rise of profits, still business prospects become gradually brighter. Old debts have been paid, accumulated stocks of commodities have been absorbed, weak enterprises have been reorganized, the banks are strong-all the clouds upon the financial horizon have disappeared. Everything is ready for a revival of activity, which will begin whenever some fortunate circumstance gives a sudden fillip to demand, or, in the absence of such an event, when the slow growth of the volume of business has filled order books and paved the way for a new rise of prices. Such is the stage of the business cycle with which the analysis began, and, having accounted for its own beginning, the analysis ends.