Economics Volume II: Modern Economic Problems

by Frank A. Fetter

§ 11. #The use of credit.# Most noteworthy of these objective conditions is the general use of credit. The credit system greatly enhances the rhythm of price. If the value of a thing that is fully paid for falls, the owner alone loses; but if the value of a thing only partly paid for falls so much that the owner is forced to default in his payment, the loss may be transmitted along the line of credit to every one in a long series of transactions. A credit system, highly developed, is a house of cards at a time of financial stress. Demand liabilities are at such a time the greatest danger, so that the banks, ordinarily the pillars of financial strength, become at such a time the points of greatest weakness in the financial situation. If many of the customers were not restrained by their sense of personal obligation to the banks, by the strong pressure which the banks can bring to bear upon them, or by the force of public opinion among business men, from withdrawing the balances to their credit in a time of crisis, all commercial banks would become insolvent at once in a crisis by the very nature of their business; for all their ordinary deposits are nominally payable on demand.

§ 12. #Interest rates in a crisis.# In normal times there is always outstanding a great mass of short-time, commercial loans.[11] The motive of the borrower, in most cases has been to hire more labor and to buy more materials for use in his business. Ordinarily these loans can and are renewed without difficulty or are replaced by others, based on the security of new business transactions in unbroken succession. Now at the time of a crisis a general contraction of credit occurs, and all borrowers with maturing obligations are faced with bankruptcy. The effort of the business man at such a time is not to make a positive profit, but to save what he can from the threatened wreck. The demand for short-time loans, therefore, in such times of stress, fluctuates rapidly, and exceedingly high interest rates prevail in these loan markets for a few days or a few weeks, rates which have only a remote relationship with the usual capitalization of most agents.

The distress of the business man is magnified by the fact that it is just at such times that both the equipment he has bought and the products he has made become temporarily almost unsaleable at prices as high as he paid for them when he bought them with the borrowed money. He may know that prices will soon be higher, but he cannot wait. Various courses are open to him in this emergency; he may borrow the money at a very high rate of interest, holding the goods for better prices; or he may sell the goods under the unfavorable conditions; or he may sell other capital such as stocks and bonds. The end sought is the same—to get ready money; and the methods are not essentially unlike—the exchange of greater future values for smaller present values. The sacrifice sale thus reveals the merchant's high estimate of present goods in the form of money. The purchaser of some kinds of property in times of depression is securing them at a lower capitalization than they will later have. The rise in value may be foreseen as well by seller as by buyer, but the low capitalization reflects the high interest rate temporarily obtaining. A.T. Stewart, once the most famous New York merchant, is said to have laid the foundation of his fortune when, being out of debt himself, he bought up the bankrupt stocks of his competitors in a great financial panic. The high interest at such times is but the reflection of the high premium on present purchasing power.

The worst of the evils of crises are confined to the markets where the greatest numbers of short-time loans are made. Most of the long-time loans do not fall due in such seasons of stress, and the great mass of slowly exchanging wealth alters little and slowly in price. Such loans as fall due can generally be renewed for long periods at rates little higher than usual, the market for long-time and short-time loans being in large measure independent of each other. But they are not quite independent, and some lenders take whatever sums they can collect on maturing long-time obligations and loan them on short terms at high rates of interest, or buy goods, whole enterprises, bonds, and stocks, at the unusually low prices temporarily prevailing. The effect of this is to raise somewhat the interest rate on long-time paper to accord with the new conditions.

§ 13. #Dynamic conditions and price readjustments.# Another condition favorable to the rhythmic movement of capitalization is a dynamic economic society. The past century has opened up new fields for investment on an unexampled scale. Investment has advanced both intensively and extensively in a series of great waves. New machinery and processes have given undreamt of opportunities for enterprise in the older countries, and the physical frontier of investment has moved outward with the march of millions of immigrants to people the fertile wilderness. Such factors disturb the equilibrium of prices both in time and space, give a powerful impulse toward higher values in the older lands, and stimulate the hopes of all investors. When the balance between the capitalizations of various industries and between the incomes of the various periods proves to be false, the inevitable readjustment causes suffering and loss to many, but particularly in the inflated industries. But, because of the mutual relations of men in business, few even of those who have kept freest from speculation can quite escape the evils.

Among the dynamic conditions in industry are changes in the general price level whether due to changes in the production of the standard money commodity (relative to population) or to changing methods of doing business. If the price level is falling (i.e., the standard unit is appreciating), the burden of the great mass of outstanding debts is growing heavier upon the debtors.[12] Sooner or later some of them break down under its weight. At such times many attempt to shift their capital from active investments such as stocks, to passive investments such as bonds. When the price level is rising, the opposite conditions prevail. But such adjustments proceed uncertainly and unevenly in different industries, with much speculation in shifting from one type of business to another, and with much accompanying miscalculation.

§ 14. #Tariff changes and business uncertainty.# Another variable influence in American business has been the tariff. Every tariff revision, whether the rates go upward or downward, shifts somewhat the relative opportunities and profitableness of different industries. Some of these call for far-reaching readjustments of investments and of productive forces. Some persons gain and some lose by every such change. It is observed that a reduction of tariff rates seems to have a more disturbing effect upon business than does an increase. This probably is because the industries favored by protective tariffs in America are those most fully within the circle affected by crises; whereas most of the consumers adversely affected by a rise of tariff rates are outside the commercial circles where short-time credit is common and where the rapid readjustment of investment leads to a financial crisis. It never has been convincingly shown, however, that there is any large measure of correspondence in time (not to say causal relation) between tariff revisions and crises.[13]

§ 15. #Rhythmic changes in weather and in crops#. A psychological movement, once started, accumulates force and momentum up to a certain point where a reaction begins. This rhythmic movement as it appears in the capitalization of enterprises is favored and magnified, we have seen, by the wide use of credit and by the constantly changing technical and physical conditions of industry. These call for constant revaluations of the sources of incomes, thus destroying customary and habitual valuations. But why should the cycle begin or end at one point of time rather than at another; and what determines the length of the cycle? Some of the new dynamic forces such as inventions and growth of population are distributed pretty regularly along the line, so that their influences are nearly equalized. But occasionally some large impulse may serve to start a swing and if this impulse is somewhat regularly repeated, it may serve to keep up the rhythmic motion. True, the lack of coincidence in the impact of various influences which occur accidentally, such as political changes, wars, and the rapid opening of new routes of transportation, would serve to hasten or to retard, perhaps for a time quite to alter, what would otherwise be the rhythm of the cycle. That there is nevertheless, a noticeable degree of regularity in the recurrence of crises may be due to the presence of one dominating factor.

Alternation of good and poor harvests has always seemed to be favorable to business prosperity. In America since about 1865, farm products have constituted the larger part of our exports, so that a succession of large harvests has usually acted to stimulate exports (one of the features of a period of prosperity), to give us a larger credit balance in international trade, and to reduce the rate of exchange. Large harvests of the staple agricultural crops in America have been known to be closely related to the amount of rainfall in the three most important growing months. Recently, it has been shown that the rainfall of the Ohio Valley occurs in cycles of about eight years, and in a larger cycle of thirty-three years. The cycle of yield per acre of the nine principal crops is shown to correspond closely with the cycle of pig iron production (one of the best single indices of growing business) dated one to two years later.[14] As the cycles of rainfall and of harvests are not coincident in different countries, it will require further study to adjust to these observations the fact of the world-wide extent of the great financial crises. But a better understanding of objective conditions of this kind will give fuller meaning to the psychological interpretation of crises.

§ 16. #Remedies for crises#. The financial crisis must be looked upon as an economic disease which brings many evils in its train. The need is not merely to mitigate the severity of the brief period of crisis, but also to smooth out the curve of the business cycle so as to reduce periodic unemployment, the lottery element in profits, and the number of unmerited failures in business. Several measures may aid toward this end. In the past the crisis has been more severe in America than in Europe because of certain well-recognized defects which now have been largely remedied in the Federal Reserve Act.[15] The provisions whereby any one may get credit on good commercial assets should make it impossible for a crisis to degenerate into a panic. This legislation has provided springs to reduce the jolt of the change from a higher to a lower level of prices.