Financing a Cycle No business cycle theory was ever built solely on waves of optimism and pessimism, but many considered these waves an important part of the explanation of the cycle. Suppose for some reason businessmen become more optimistic, and as a result begin to increase inventories and build new factories. Their optimism could be self-fulfilling, for as output expands, income and consumption will also increase. If in turn the extra spending leads to even more optimism, a self-feeding process of growth would take place. But sales cannot continue to increase indefinitely because of supply limitations (the economist's concept of the production-possibilities frontier). When full capacity is reached, growth slows and stops, and businessmen realize that they have become too optimistic. They then revise downward their expectations and become pessimistic. This can also lead to a self-feeding process, this time downward. Production is cut, and thus employment and income. Consumers buy less, and business gets even more pessimistic. The contraction eventually stops when businessmen realize that they have become too pessimistic, which turns the process around again. Two items are noteworthy in this view of the cycle. First, it assumes that financing needed to purchase the goods could expand and contract as needed, and second, there is an emphasis on the importance of investment spending. If an economist focused either on the expansion and contraction of financing or on the fluctuations in investment, he could easily build in waves of optimism and pessimism as part of the structure of things that should be taken as given. In fact most business cycle theories that fit the business-cycle model of the first section emphasize either monetary factors or investment. An example of a monetary theory of the business cycle is that of R.G. Hawtrey, an English economist of the early 20th century. Hawtrey's theory was a dynamic variant of the quantity theory of money. His theory centered on fluctuations in bank credit and demand deposits, the process by which banks create and destroy money. Hawtrey began with an economy that was initially at rest. For some reason the interest rate dropped. The drop in interest rate would cause merchants to demand more bank credit, and in the process of granting loans to the merchants, banks would create money. The increase in orders by business increases income and hence would generate more spending. Further, said Hawtrey, not only would money increase, but velocity would as well. People would tend to spend their money faster in good times than they do in bad times. The process is cumulative or self-feeding because the increase in money increases total spending which gives merchants a further inducement to borrow. The upswing would be stopped by bank reserves, either gold in a country with a gold standard or by central-bank authority in other cases. Hawtrey's argument here makes more sense in situations in which there are no reserve requirements established with the force of law. In these situations each bank must decide for itself whether it has sufficient reserves to meet unexpected withdrawals. When such systems were in force, actual reserve ratios showed considerable fluctuation. In Hawtrey's upswing reserves were constant, and as more and more money was created, the ratio of reserves to money fell. Eventually it would reach a level at which banks began to feel uncomfortable, and they would then stop increasing loans. The stoppage of money growth halted the upswing, and could turn it around into a self-feeding decline. The lower turning point would be reached when banks felt that their reserve-to-deposit ratio were too low and cut interest rates to spur borrowing. Hawtrey did not believe that the cycle would necessarily be periodic, that is, with a constant length of time from peak to peak. The many accidental and unpredictable forces affecting the economy could shorten or lengthen any particular upswing or downswing. Thus Hawtrey deviated a bit from the framework we described earlier (but most other business-cycle writers did too). Hawtrey also considered the possibility that an economy could break through the lower boundary and become trapped with what he called a "credit deadlock." If business activity became too depressed, even very low interest rates might not induce merchants to borrow more, and thus there would be no turn-around. In exploring this possibility, Hawtrey echoed Henry Thornton who in 1802 warned against severe reductions of the stock of paper money to prevent an outflow of gold. Thornton believed that too severe a reduction would destroy the forces that correct the problem of the gold outflow. Hawtrey foreshadowed the liquidity trap of John Maynard Keynes that also describes conditions in which the economy could become severely depressed without recuperative powers. Notice that Hawtrey's cycle violated all three assumptions of the long-run quantity theory of money. Other writers, such as Irving Fisher, who proposed monetary theories of business fluctuations, also violate all three assumptions. First, Hawtrey allowed velocity to change, rising when business activity is high and falling when it is low. The effect of this pattern is to magnify changes in money—a 10% change in money stock will have more than a 10% change in total spending. Note that this is not inconsistent with the quantity theory of money if the quantity theory is seen only as a long-run, equilibrium proposition. A discussion of business cycles is a discussion of what happens in the short run, when adjustment is taking place. Second, though changes in money stock affect total spending, there is feedback so that a change in total spending also affects money. Again, this need not contradict the quantity theory if the quantity theory is seen as a long-run theory because feedback only takes place in the short run. However, the feedback mechanism that Hawtrey described is unlikely to be of great importance today in most countries. Reserves are no longer left to the discretion of commercial banks. Rather central banks proscribe minimum reserve requirements. The amount of reserves a bank is required to hold is usually greater than the amount it would like to hold, which explains why variations in the reserve ratio are of negligible importance today in explaining fluctuations in money stock. Central banks, which have learned to act as lender of last resort, and deposit insurance have largely eliminated bank runs, another source of monetary instability in the 19th century. Hawtrey's theory may have had merit at one time, but Hawtrey himself believed that once Western countries abandoned the gold standard in 1914, a mechanism that gave the cycle regularity was destroyed. Certainly his theory no longer explains the interactions between money stock and economic activity. Third, changes in money affect not just prices, but output. Only in the long run is money "neutral," without effects on output. While most of the business cycle literature discussed money, most of it also took a careful look at investment and savings. Copyright Robert Schenk