America's Great Depression (17 page)

Technology is perhaps the most emphatically stressed of these alleged causal factors. Schumpeter’s cycle theory has led many economists to stress the importance of technological innovation, particularly in great new industries; and thus we hear about the Railroad Boom or the Automobile Boom. Some great technological innovation is made, a field for investment opens up, and a boom is at hand. Full exploitation of this field finally exhausts the boom, and depression sets in. The fallacy involved here is neglect of the fact that technology, while vitally important, is only
indirectly
, and not directly, involved in an investment. At this point, we see again why the conditions of Misesian rather than Walrasian equilibrium should have been employed. Austrian theory teaches us that investment is always
less
than the maximum amount that could possibly exploit existing technology. Therefore, the “state of technical knowledge” is not really a limiting condition to investment. We can see the truth of this by simply looking about us; in every field, in every possible line of investment, there are always
some
firms domain permanently. Nowadays, outer space will presumably provide “frontier” enough.

Some Alternative Explanations of Depression: A Critique
71

which are
not
using the latest possible equipment, which are still using older methods. This fact indicates that there is a narrower limit on investment than technological knowledge. The backward countries may send engineers aplenty to absorb “American know-how,” but this will not bring to these countries the great amount of investment needed to raise their standard of living appreciably.

What they need, in short, is
saving
: this is the factor limiting investment.19 And saving, in turn, is limited by time preference: the preference for present over future consumption. Investment always takes place by a lengthening of the processes of production, since the shorter productive processes are the first to be developed.

The longer processes remaining untapped are more productive, but they are not exploited because of the limitations of time-preference. There is, for example, no investment in better and new machines because not enough saving is available.

Even if all existing technology were exploited, there would
still
be unlimited opportunities for investment, since there would still not be satiation of wants. Even if better steel mills and factories could not be built,
more
of them could always be built, to produce more of the presently produced consumer goods. New technology improves productivity, but is not essential for creating investment opportunities; these
always
exist, and are only limited by time preferences and available saving. The more saving, the more investment there will be to satisfy those desires not now fulfilled.

Just as in the case of the acceleration principle, the fallacy of the

“investment opportunity” approach is revealed by its complete neglect of the price system. Once again, price and cost have disappeared. Actually, the trouble in a depression comes from
costs
being greater than the
prices
obtained from sale of capital goods; with costs greater than selling prices, businessmen are naturally reluctant to invest in losing concerns. The problem, then, is the rigidity of costs. In a free market, prices determine costs and not
vice versa
, so that reduced final prices will also lower the prices of productive 19
Saving,
not monetary expansion. A backward country, for example, could not industrialize itself by issuing unlimited quantities of paper money or bank deposits. That could only bring on runaway inflation.

72

America’s Great Depression

factors—thereby lowering the costs of production. The failure of

“investment opportunity” in the crisis stems from the overbidding of costs in the boom, now revealed in the crisis to be too high relative to selling prices. This erroneous overbidding was generated by the inflationary credit expansion of the boom period. The way to retrieve investment opportunities in a depression, then, is to permit costs—factor prices—to fall rapidly, thus reestablishing profitable price-differentials, particularly in the capital goods industries. In short, wage rates, which constitute the great bulk of factor costs, should fall freely and rapidly to restore investment opportunities. This is equivalent to the reestablishment of higher price-differentials—higher natural interest rates—on the market.

Thus, the Austrian approach explains the problem of investment opportunities, and other theories are fallacious or irrelevant.

Equally irrelevant is all discussion in terms of specific industries

—an approach very similar to the technological opportunity doctrine. Often it is maintained that a certain industry—say construction or autos—was particularly prosperous in the boom, and that the depression occurred because of depressed conditions in that particular industry. This, however, confuses simple specific business
fluctuations
with general business
cycles
. Declines in one or several industries are offset by expansion in others, as demand shifts from one field to another. Therefore, attention to particular industries can
never
explain booms or depressions in general business—

especially in a multi-industry country like the United States.20 It is, for example, irrelevant whether or not the construction industry experiences a “long cycle” of twenty-odd years.

SCHUMPETER’S BUSINESS CYCLE THEORY

Joseph Schumpeter’s cycle theory is notable for being the only doctrine, apart from the Austrian, to be grounded on, and integrated 20The economic fortunes of a small country producing one product for the market will of course be dominated by the course of events in that industry.

Some Alternative Explanations of Depression: A Critique
73

with, general economic theory.21 Unfortunately, it was grounded on Walrasian, rather than Austrian, general economics, and was thus doomed from the start. The unique Schumpeterian element in discussing equilibrium is his postulate of a zero rate of interest.

Schumpeter, like Hansen, discards consumer tastes as an active element and also dispenses with new resources. With time preference ignored, interest rate becomes zero in equilibrium, and its positive value in the real world becomes solely a reflection of positive profits, which in turn are due to the only possible element of change remaining: technological innovations. These innovations are financed, Schumpeter maintains, by bank credit expansion, and thus Schumpeter at least concedes the vital link of bank credit expansion in generating the boom and depression, although he pays it little actual attention. Innovations cluster in some specific industry, and this generates the boom. The boom ends as the inno-vatory investments exhaust themselves, and their resulting increased output pours forth on the market to disrupt the older firms and industries. The ending of the cluster, accompanied by the sudden difficulties faced by the old firms, and a generally increased risk of failure, bring about the depression, which ends as the old and new firms finally adapt themselves to the new situation.

There are several fallacies in this approach: 1. There is no explanation offered on the lack of accurate forecasting by both the old and new firms. Why were not the difficulties expected and discounted?22

21Schumpeter’s pure theory was presented in his famous
Theory of Economic
Development
(Cambridge, Mass.: Harvard University Press, 1934), first published in 1911. It later appeared as the “first approximation” in an elaborated approach that really amounted to a confession of failure, and which introduced an abundance of new fallacies into the argument. The later version constituted his
Business
Cycles,
2 vols. (New York: McGraw–Hill, 1939).

22To be sure, the Schumpeterian “Pure Model” explicitly postulates perfect knowledge and therefore absence of error by entrepreneurs. But this is a fla-grantly self-contradictory assumption within Schumpeter’s own model, since the very
reason
for depression in the Pure Model is the fact that risks increase, old firms are suddenly driven to the wall, etc., and no one innovates again until the situation clears.

74

America’s Great Depression

2. In reality, it may take a long time for a cluster of innovations in a new industry to develop, and yet it may take a relatively short time for the output of that industry to increase as a result of the innovations. Yet the theory must assume that output increases after the cluster has done its work; otherwise, there is no boom nor bust.

3. As we have seen above, time preferences and interest are ignored, and also ignored is the fact that saving and not technology is the factor limiting investment.23 Hence, investment financed by bank credit need not be directed into innovations, but can also finance greater investment in already known processes.

4. The theory postulates a periodic cluster of innovations in the boom periods. But there is no reasoning advanced to account for such an odd cluster. On the contrary, innovations, technological advance, take place continually, and in most, not just a few, firms.

A cluster of innovations implies, furthermore, a
periodic cluster of
entrepreneurial ability
, and this assumption is clearly unwarranted.

And insofar as innovation is a regular business procedure of research and development, rents from innovations will accrue to the research and development departments of firms, rather than as entrepreneurial profits.24

5. Schumpeter’s view of entrepreneurship—usually acclaimed as his greatest contribution—is extremely narrow and one-sided.

He sees entrepreneurship as solely the making of innovations, setting up new firms to innovate, etc. Actually, entrepreneurs are continually at work,
always adjusting
to uncertain future demand and supply conditions, including the effects of innovations.25

23Schumpeter wisely saw that voluntary savings could only cause simple economic growth and could not give rise to business cycles.

24See Carolyn Shaw Solo, “Innovation in the Capitalist Process: A Critique of the Schumpeterian Theory,”
Quarterly Journal of Economics
(August, 1951): 417–28.

25This refutes Clemence and Doody’s defense of Schumpeter against Kuznets’s criticism that the cluster of innovations assumes a cluster of entrepreneurial ability. Clemence and Doody identified such ability solely with the making of innovations and the setting up of new firms. See Richard V. Clemence and Francis S. Doody,
The Schumpeterian System
(Cambridge, Mass.: Addison Wesley
Some Alternative Explanations of Depression: A Critique
75

In his later version, Schumpeter recognized that different specific innovations generating cycles would have different “periods of gestation” for exploiting their opportunities until new output had increased to its fullest extent. Hence, he modified his theory by postulating an economy of
three
separate, and interacting, cycles: roughly one of about three years, one of nine years, and one of 55 years. But the postulate of multi-cycles breaks down any theory of a general business cycle. All economic processes interact on the market, and all processes mesh together. A cycle takes place over the entire economy, the boom and depression each being
general
. The price system integrates and interrelates all activities, and there is neither warrant nor relevance for assuming hermetically-sealed “cycles,” each running concurrently and adding to each other to form some resultant of business activity. The multi-cycle scheme, then, is a complete retreat from the original Schumpeterian model, and itself adds grievous fallacies to the original.26

QUALITATIVE CREDIT DOCTRINES

Of the theories discussed so far, only the Austrian or Misesian sees anything wrong in the boom. The other theories hail the boom, and see the depression as an unpleasant reversal of previous prosperity. The Austrian and Schumpeterian doctrines see the depression as the inevitable result of processes launched in the boom. But while Schumpeter considers “secondary wave” deflation unfortunate and unsettling, he sees the boom–bust of his pure model as the necessary price to be paid for capitalist economic development. Only the Austrian theory, therefore, holds the inflationary boom to be wholly unfortunate and sees the full depression Press, 1950), pp. 52ff; Simon S. Kuznets, “Schumpeter’s Business Cycles
,”
American Economic Review
(June, 1940): 262–63.

26Schumpeter also discusses a “secondary wave” superimposed on his pure model. This wave takes into account general inflation, price speculation, etc., but there is nothing particularly Schumpeterian about this discussion, and if we discard both the pure model and the multicycle approach, the Schumpeterian theory is finished.

76

America’s Great Depression

as necessary to eliminate distortions introduced by the boom. Various “qualitative credit” schools, however, also see the depression as inevitably generated by an inflationary boom. They agree with the Austrians, therefore, that booms should be prevented before they begin, and that the liquidation process of depression should be allowed to proceed unhampered. They differ considerably, however, on the causal analysis, and the specific ways that the boom and depression can be prevented.

The most venerable wing of qualitative credit theory is the old Banking School doctrine, prominent in the nineteenth century and indeed until the 1930s. This is the old-fashioned “sound banking” tradition, prominent in older money-and-banking textbooks, and spearheaded during the 1920s by two eminent economists: Dr.

Benjamin M. Anderson of the Chase National Bank, and Dr. H.

Parker Willis of the Columbia University Department of Banking, and editor of the
Journal of Commerce
. This school of thought, now very much in decline, holds that bank credit expansion only generates inflation when directed into the wrong lines, i.e., in assets other than self-liquidating short-term credit matched by “real goods,” loaned to borrowers of impeccable credit standing. Bank credit expansion in such assets is held not to be inflationary, since it is then allegedly responsive solely to the legitimate “needs of business,” the money supply rising with increased production, and falling again as goods are sold. All other types of loans—whether in long-term credit, real estate, stock market, or to shaky borrowers—are considered inflationary, and create a boom–bust situation, the depression being necessary to liquidate the wasteful inflation of the boom. Since the bank loans of the 1920s were extended largely in assets considered unsound by the Banking School, these theorists joined the “Austrians” in opposing the bank credit inflation of the 1920s, and in warning of impending depression.