Investment and Saving
A problem that some economists saw in a purely monetary
theory was that it did not explain why most of the changes
in production over the cycle were in the form of investment.
Consumption spending varied little over the cycle, while
investment spending showed large increases and decreases.
Two very different sorts of ideas arose in an attempt to
explain why investment showed such large swings. Gottfried
Haberler groups one set of ideas together under the banner
of "overinvestment" theories. The other set of
theories is commonly referred to as
"underconsumptionist" theories.
The overinvestment theories formed the largest group of
business-cycle theories. All of them assumed that the stock
of money would swing with movements in investment because
increased spending must be financed. Some of the
overinvestment theories put considerable stress on monetary
factors and Haberler grouped them together as theories of
"monetary overinvestment." Others kept the monetary factors
in the background, and Haberler grouped them together as
theories of "nonmonetary overinvestment." Uniting all,
however, is the idea that disturbances in the economy are
not purely of monetary origin. The market for goods and
services also contributes to macroeconomic disturbances.
Overinvestment theories were based on the ideas of Knut
Wicksell, who suggested that there was a "natural"
interest rate, a rate at which the supply of savings would
equal the demand for investment. If banks were in the
process of creating money, they would supply additional
funds to the loanable-funds market, and this addition would
push the bank rate below the natural rate. In these
conditions the economy would expand. If banks were
destroying money, the bank rate would exceed the natural
rate, causing reduced borrowing and economic
contraction.
In Wicksell's model the natural rate, the demand curve
for investment, and the supply curve of savings could not be
observed. Further, banks conducted business by setting a
rate at which they would loan funds, and if they felt that
they were lending too much, they would raise that rate, and
if they felt that they were lending too little, they would
lower that rate. In this procedure banks were like any
retailer that can change sales by changing price.
Suppose, said Wicksell, that bankers lowered their rate
below the natural rate. Borrowers would then want to buy
more funds, leading to an increase of spending in the
economy. Increased spending is infectious. As economic
activity expands, businesses want to borrow more, and the
natural rate would rise even higher above the bank rate. A
cumulative expansion would begin.
As the expansion continued, banks would find that their
deposits would grow, but their legal reserves (usually in
the form of gold in Wicksell's day) would remain the same.
Ultimately banks would decide that the ratio of deposits to
reserves had risen far enough, and would increase their
interest rates to discourage borrowing. This action would
set the bank rate above the natural rate and would set the
stage for a self-feeding contraction.
Up to this point there is not much difference between
Wicksell and Hawtrey. A change in money started the
expansion, and monetary factors set the upper boundary of
the expansion. However, Wicksell's framework also allows a
change in investment to be the initiating factor, a
possibility that Hawtrey downplayed.
Suppose that the economy is at equilibrium, and that an
innovation, such as the development of railroads or the
automobile, increases the profitability of investment. As a
result, the natural rate rises. Though banks keep the prices
on loans at the old rates, there will be an increase in
borrowing as the innovators and their imitators begin to
invest. As the new investment projects are undertaken,
business borrows. A self-feeding expansion gets underway.
The expansion depends on an "elastic currency," the ability
of the banking system to provide the extra funds needed to
support the extra spending, but the elastic currency is seen
as a passive element. The actual expansion is fueled partly
by increased optimism, partly by the increased income and
hence increased consumption that the new investment creates,
and partly by the accelerator principle (discussed in the
next section).
Note that overinvestment theories do not directly oppose
monetary theories. Most economists who formulated
overinvestment theories also believed that the quantity
theory of money was valid. Most overinvestment authors
believed that without the expansion of bank credit, the
expansion could not get started or continue long enough to
become a boom. Further, the belief that the added investment
which formed the main part of the boom was financed with new
bank credit yielded a reason for an upper turning point.
The increase in investment was not financed by voluntary
savings but by funds that the banking system was creating.
Hence, there was a divergence between the structure of
production and the flow of funds. The amounts that people
wanted to save were less than the amounts that businesses
wanted to invest. It is in this sense that there was
"overinvestment." Once the increase in bank credit came to
an end, which it had to do if the economy was to avoid
ever-increasing inflation, this divergence between desired
savings and investment would reveal itself. Some businesses
would be unable to finance their planned investment, the
boom would come to an end. The same forces that propelled
the upturn would now work in reverse to propel the downturn.
Common in overinvestment theories was a belief that the boom
was a result of unbalanced growth, and this unbalance set an
upper turning point. The resulting recession "cleansed" the
economy, and when properly "cleansed," it would hit the
bottom turning point and turn upward again.
Wicksell's analysis, and the overinvestment theories that
came from it, tied together the money market and the goods
market. A disturbance could begin in either one. Linking
these markets together were the interest rate and the
financial markets.
Before 1930, economists concerned with how businesses
plans to invest would be matched with people's plans to save
usually developed some sort of overinvestment theory. But on
the fringes of economics there was another theory that
suggested that people would tend to save too much relative
to the amounts businesses wanted to invest, or in other
words, that people would "underconsume." This view was at
the heart of a dispute between Thomas Malthus and most other
economists of his day. No one developed a theory of business
cycles around this view (though it was an element in
several), for it was a theory not of a cycle but of
depression. Few prominent economists of the 1920s could have
guessed that the underconsumptionist view of the
world was about to leave the fringes, move to the center of
macroeconomics, and totally eclipse the overinvestment
theories. Yet it did. The income-expenditure model that John
Maynard Keynes developed had a strong underconsumptionist
base.
Let's speed on to the next topic on our tour of
business-cycle ideas, something called the accelerator
principle.
Copyright
Robert Schenk
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