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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.

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Copyright Robert Schenk