Lavington’s 1922 „The Trade Cycle: An Account of the causes producing rhythmical changes in the activity of business“: A Reappraisal1

Abstract:

In 1922, Fredrick Lavington published his book „The trade cycle: an account of the causes producing rhythmical changes in the activity of business“. It is one of the first academic writings explicitly linking business activity and unemployment with a focus on the banking system. Building his own theory on the quantity theory of money, Lavington recognizes that changes in the quantity of paper money and variations in bank loans influence the price level and hence business activity. More precisely, the volume of promises to pay would be one of the main causes of cyclical price fluctuations. Lavington stresses the role of expectations of profits in determining present business activity. He explains that booms contain the cause of the following bust as the the boom is contained by the supply of legal tender money, which, however, could be be extended by additional supplies of Treasury notes.

Lavington argues in favor of counter-cyclical monetary in order to tame the fluctuations and the resulting unemployment. He discards fiscal policy. The paper summarizes the theory of Lavington’s trade cycle and then seeks to establish a link towards the theories of Wicksell, Schumpeter, Keynes and Minsky. It is then applied to the Great Financial Crisis and compared to contemporary economic textbook theory. We find that the book provides us with important contributions regarding the trade cycle that are currently not prominently featured in the academic literature or textbooks of today.

Keywords: trade cycle, fiscal policy, monetary policy, psychology

JEL-Codes: B13, E31, E32

1 The author would like to thank Helge Peukert for pointing out Lavington’s book.

Seite 1 von 23 1. Introduction

In the wake of the Great Financial Crisis interest in the business cycle has been revived. Economists have revisited the role of private debt in the economy. The correlation of the growth of net lending and economic growth has been stressed by Keen (2017), among others. He notes that private debt is currently at record levels in many countries and that this means that we might experience another financial crisis soon. Dalio (2018), an investor, has published an extensive examination of „Big Debt Crises“, stressing the role of private debt as a driver of the economy. Bezemer (2009) stresses that theories that build on balance sheets were indeed correct in pointing out mechanism underlying the Great Financial Crisis, while Hudson (2015) stresses the importance of finance, insurance and real estate for the economy.

On the policy side, there is renewed interest in economic policy. In the US, the Trump administration is trying to get the Fed to lower interest rates or at least not raise them, recognizing that the interest rate is the main instrument of monetary policy and believing it to be one of the key determinants of economic growth. On the other side of the political spectrum, Modern Monetary Theory (MMT) has been moved into the public debate, stressing that as monopoly issuer of currency the State cannot go bankrupt for technical reasons as long as all public debt is denominated in domestic currency. The policy conclusion is that current DSGE models with their estimates of potential output and „natural rates of unemployment“ are too restrictive. More expansionary economic policy would therefore lead the economy back towards full employment under price stability.

The current theme of all these debates is the stabilization of the business cycle. If market forces would lead us towards full employment price stability, then we would not need economic policy at all. The central bank’s set of interest rates could be „parked“ at zero or whatever number is convenient, and government spending could be bound by a rule, like a debt brake.2 This, however, is by now unrealistic. While economists largely ignored Japan and its macroeconomic troubles that started in the early 1990s, de-leveraging and private debt overhangs are by now widely discussed. The Eurozone has troubles of its own making, binding government solvency to market sentiment with regard to sovereign securities. This set

2 See Rochon and Setterfield (2007) for a discussion on „parking“ the interest rate.

Seite 2 von 23 up has delivered a fierce combination of bank bail-outs and mass unemployment that now threatens to unravel not only the Euro, but the whole European project.

This, then, is a good time to look back at economic history. Business cycle research has existed at least from the late 19th century onward.3 Interest was strongest during the Great Depression, when it became obvious to all that market forces would not lead the economy back to full employment and price stability. This period is rather well understood. The writings of John Maynard Keynes, which made a comeback in recent years, have been examined at length in the economics discipline. One of his most important results is the rejection of the notion of (economic) equilibrium. Besomi (2019, p. 294) notes: “The terminology changes [in Keynes’ General Theory]: the cycle is no longer understood in terms if ‚the oscillations of the terms of trade about their equilibrium position‘ (Keynes 1930 [1971], p. 165), but as fluctuations in the volume of employment and output driven by changes in the volume of investment – a phenomenon he now calls ‘trade cycle’, the expression most commonly used in Britain after Lavington’s (1922) book of the same title.” Instead of some equilibrium process, the economy was now driven by investment, private and public. Komine (2014, 65) saw in Lavington „an important catalyst in the lead up to this revolution“, referring to Marshall’s dichotomy of an efficient long-run equilibrium and short- run abnormalities.

In his General Theory, Keynes (1936) devoted eight out of twenty-four chapters on investment, highlighting its importance. Instead of supply and demand, the economy is driven by mass psychology.4 He famously writes: „professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.“ Haberler (2014 [1937], 143) recognizes that “[t]he writers who have laid

3 See Boianovsky and Hagemann (2002) for a collection of writings from the early period of business cycle research.

4 Supply and demand are still in operation, but they are driven by psychology and are not mechanical reflections of microeconomic decisions under certainty. The interest rate, for instance, is determined by liquidity preference.

Seite 3 von 23 greatest stress on ‘psychological’ reactions in the explanation of the various phases of the cycle are KEYNES, LAVINGTON, PIGOU and TAUSSIG”.

Given that much of what Keynes and „the Classics“ had written about economics was lost to most of the current generation of young economists and Keynes only went so far as to publish a chapter of „Notes on the trade cycle“, it seems worth wile to revisit Lavington’s book on the trade cycle and examine which concepts and theories were put forward.5 After summarizing the book, his ideas will be applied to the Great Financial Crisis and compared to the economic theory writings of Joseph Schumpeter, John Maynard Keynes and Hyman Minsky, whose theories have often been revisited in the last ten years.6

2. The book

Lavington, who builds on the quantity theory of money, published his book in 1922. It is somewhat odd that only four years after WW I a book on the trade cycle would be published. As Cannan (1922) notes in his book review, the economy was driven not by private investment, but by the government expenditures relating to the war. Lavington recognizes this fact but nevertheless proceeds to think about how to stabilize the economy after the end of the hostilities. He was not alone. Other books on the topic of trade or business cycles were Mitchell (1923), Marshall (1923), Robertson (1926), Pigou (1927), Hawtrey (1928) and Mises (1928). Boianovsky and Hagemann (2002) in the introduction of their volume III present a nice overview of that period.

In his preface (p. 7), Lavington acknowledges the writings of Marshall, Pigou, Robertson, Mitchell and Aftalion. Lavington (1881-1927) was a lecturer at the University of Cambridge. He worked as a banker for ten years before starting his studies, becoming one of the first students of John Maynard Keynes. He belonged to the Marshallian school and was famous for his quip „It’s all in Marshall, if one only digs deeply enough“.7 Marshall (1923) in book IV

5 Bridel (1987) discusses Lavington and Keynes in the context of Cambridge monetary thought, but his focus lies on saving-investment analysis.

6 See Bateman (2010), Dimand and Hagemann (2019), Kurz et al. (2010), Wray (2015) and Sandelin (2011).

7 See Groenewegen (2017) for more biographical details.

Seite 4 von 23 titled „Fluctuations of Industry, Trade and Credit“ presents his view of the trade cycle. In order to make sense of Lavington’s book a sketch of Marshall’s theory is presented.

Marshall sees technical progress as responsible for the phenomenon of the trade cycle. During the boom, some additional „book credits“ will be granted, leading to a rise in wages, then prices and then profits. Bankers supply of credit subsequently decreases as they read the sign of the times (a looming boom which must end in a bust), while demand increases. This leads to a rise in the rate of interest. A „commercial storm“ follows, also because of the gold standard mechanism. The exchange rate would fall, which would lead to less demand for credit and hence increase the strength of the downturn. Marshall stresses bulls and bears as well as „moods“. Marshall (1923, 255) argues that „forced interruption to labour is a grievous evil“. He connects expansion and contraction of credit with rises and falls in prices. Marshall (1923, 256) suggests to make „long-term contracts in official units of general purchasing power“. This would render the employment of industry workers more steady and continuous.

Lavington starts bis book with the economic situation of his day. „Ample resources vainly seek employment, and urgent wants vainly seek satisfaction, the impediments must be very powerful which prevent the adjustment of the one to the other“ (p. 9-10). The post-war boom just ended, with the UK unemployment rate moving up to over 10%. The price level came down. According to prevailing opinion the principal impediments would include such causes as uncertainty of prices, mistrust between workers and employers, high costs of production and the consequences of the war. Lavington (p. 14) states that „the explanation of these rhythmical movements is to be found in the characteristics of modern industrial organization.“ According to him (14-15), three clearly marked phases can be distinguished:

1. a period of rising business activity extending (on the average of a half-century) over some four years; 2. a brief interlude of apprehension whose intensity may attain to a panic; 3. a period of declining business activity roughly equal to that of the rise.

Lavington next turns towards prices, stating that on the average of the last seven cycles the general price level rose annually about 4 per cent during the period of prosperity and fell annually about 4 per cent during following periods of depression. Business profits would fluctuate in an even more extreme degree. Interest and discount rates follow the general

Seite 5 von 23 movement and wage rates follow changes in wholesale prices with a time lag of uncertain length. From this, Lavington (16) concludes „that the construction of capital goods expands and contracts in a marked degree during periods of prosperity and depression, and suggest that the output of goods in general also follows the rhythm of prices.“ He singles out the cyclical changes of business activity as the most important cause of unemployment and puts them to the forefront of his book. Physical causes as those affecting the earth’s natural yield are discarded.

In chapter three, Lavington examines „some essential conditions of modern organization“. He points out that the economic means are not adjusted to economic ends by „any supreme central authority“, but by „a specialized class of many thousands of independent entrepreneurs“ (18). The entrepreneurs would be acting on their own, hiring supplies in the markets (labour, capital, land), and producing goods that would address some small part of the needs of the community. Lavington (20) recognizes that „it is important to bear in mind that current business activity depends as much upon the merchant's will to buy as upon the manufacturer's willingness to produce.“ In modern parlance, demand would be as important as supply.8

The activity of business would depend „not on current conditions, but on the estimates which entrepreneurs form of the conditions of their markets at some distant date in the future.“ This is complicated even more by the interdependence among the entrepreneurs. The activity of each entrepreneur would be dependent on the activity of all others. Lavington (24) turns this argument around and concludes that „[t]he inactivity of all is the cause of the inactivity of each“. This insight is based on the simple logic that the expenditures of all are the biggest determinant of the incomes of each single entrepreneur. Lavington does not develop a model of a monetary circuit like that of Wicksell (1898, 138 ff.). While acknowledging the importance of expenditures and incomes, Lavington focuses on the income-expenditure view and the production side of the economy. He does not inquire about the creation and destruction of money.

Lavington (25) then turns to the concept of „effective market demand“ in the context of price determination. Prices for any commodity would be expressing the needs of consumers. A

8 Later on, Lavington gives a more prominent role to demand.

Seite 6 von 23 higher (lower) price would draw more (less) resources into production of that commodity as profits increase (decrease). This use of the term „effective demand“ mirrors the microeconomic logic underlying the price formation of resources and has nothing to do with the use of that term by Keynes.9

According to Lavington (26), price movements can also arise from „variations in the output of gold, the issue of excessive quantities of paper money or undue expansions or contractions in bank loans.“ These would be disturbing influences that would act on the price index, which then will „have lost their intelligence“ (26). Lavington is clearly building on the idea that prices are information useful for production, and that outside disturbances from the monetary system would be interfering with price formation on (free) markets.10

Lavington (26-27) proposes four characteristic features of modern organization, which are:

1. that the responsibility for production is assumed by a special class of business men, each acting on his own judgment and at his own risk; 2. that, as production takes time, its present activity depends on estimates of future conditions, on forecasts liable to error; 3. that the market for the output of each firm is dependent on the output of all others; 4. that as business estimates are based, not on prospective needs but on prospective prices, they are liable to further error from arbitrary variations in the price index.

From this he concludes that „the key to the causes of business fluctuations lies in the mind of the entrepreneur, in the influences which determine his confidence in the business future“ (27). Lavington sees a cumulative process at work, which continues „until a point is reached at which the exposure of errors in forecasts and other adverse conditions shake the confidence on which it is based and produce a condition of apprehension“. A reversal would then follow, again working out through a cumulative process.

Chapter four deals with „business confidence“. Lavington makes the cumulative process more explicit. Rising confidence would lead to an increase in loans, which would raise the general

9 See chapter three of Keynes (1936).

10 This theme connects to Leijonhufvud (1981, v-vi), who stresses „coordination failures … as the consequence of the failure of agents to perceive correctly and completely the opportunities present in the system.“

Seite 7 von 23 level of prices and emphasize conditions of confidence. All three would reinforce each other. The strength of this effect would be the greater, „the more incalculable are the conditions on which the rational judgment is based.“ The growing realization of business success would further influence business judgements, even though entrepreneurs would adjust their current activities mostly to the future. Entrepreneurs would also realize that whatever their actions are they would not escape the consequences of the following general depression.

At some point, „causes are set in motion whose effects, in the form of realized business error, destroy the confidence from which they arise and bring the period of prosperity to an end.“ With this we move on to chapter five, dealing with „The influence of price“. The main question is what explains the level of prices. Lavington continues to show how rising (declining) confidence tends to raise (lower) the price level and how these changes in the level of prices reinforce the intensity of the whole cyclical movement.

Lavington’s price theory is very simple in that the level of prices is driven by the volume of money held by the people. He defines money - a vague term - as effective purchasing power. An expansion of bank loans would lead directly to an increase in current-account balances. This would lead to a rise in expenditure and incomes and hence output.

Lavington recognizes that the bank rate, set by the central bank, drives the deposit rates set by banks. Lowering the bank rate would be „presumably to encourage this taking of money out of store and bringing it into active employment“. He brings forward the example of a speculator on the Liverpool cotton market. Purchasing large quantities of futures he would drive up both spot and future prices. This increases the quantity of promises to pay and hence effective purchasing power. The effect of this would be an increase in the price level. Lavington (45) goes so far as to say that prices are driven by demand, which is itself a function of the creation of debt:

„In each case prices are driven upward by the increased pressure of demand; in each case demand is supported by the creation of implicit promises to pay—by a creation of new purchasing power on the part of the buyer.“

Lavington concludes that the cyclical rise and fall in wholesale prices is caused by changes in the volume of promises to pay by entrepreneurs and speculators dealing in delivery of goods

Seite 8 von 23 in future markets. His underlying monetary theory is quite conventional. Bank balances, Lavington (47-8) argues, are based on legal-tender money. This includes gold and/or Treasury notes. Therefore, the expansion of bank balances is sooner or later limited by the supply of legal-tender money. This is because the increase in bank balances will be followed by an increase in cash withdrawals, which reduces the reserves in the banking system upon which their deposits are based. This „sapping the basis of bank reserves“, according to Lavington, must ultimately lead to a destruction of the confidence.

In chapters six to eight, Lavington describes „The course of a trade cycle“. He points out that any addition to the volume of buying in the upward phase will through its effect on prices tend „to justify the anticipations on which it was based“ (57-8). Increasing the production in anticipation of future demand also increases purchasing power, which will lead to higher profits. These cumulative processes will trigger a rise in private investment and „an extreme activity in the constructional trades which cannot be continued indefinitely“ (62). The reason ist that during the boom many businesses are „wastefully managed“, their success being based on exceptionally favourable conditions. Some new companies would „have no reasonable prospect of success“ (62). With the rise in credit, mutual financial commitments would increase as well, carrying with them promises to pay in the future.

This is why each boom would contain the sees of its own destruction. Legal tender money would be drained, the pyramid of bank loans and cheque currency erected on it would collapse.11 In a country with a modern monetary system the cycles would therefore have financial causes that are due to the way the monetary system is build. Lavington continues to discuss how changes in the monetary system could be used to fiddle with the cycle. If the Treasury, for instance, issued new Treasury notes as required, „the boom in all its extravagance might continue, not indefinitely but for a long time, without any limitation being imposed upon it by the operation of the monetary system“ (67). Why it cannot continue Lavington does not explain.

Lavington examines possible real causes of the business cycle, discussing an „inadequate supply of new savings“ as a break on new investment. There might also be an „excess of savings“. As this common mistake of „imbalances“ in saving and investment was

11 Lavington writes about an „artificial stimulus“.

Seite 9 von 23 subsequently put right by Keynes (1936), the rest of the discussion is omitted, What is more interesting is the discussion of the behaviour of business when they „take in sail“ as confidence falls. Lavington (77) correctly identifies that „the dangers of the situation consist simply in liabilities to pay“, which would lead entrepreneurs to increase their money balances „as a reserve against contingencies only imperfectly foreseen“. The resulting pressure to sell would lead to a rapid fall of prices if large speculative holdings financed by borrowed money would exist. This would then threaten the solvency of firms. Firms would also be inclined to hold more money in order to pick up „exceptional bargains“ later in the cycle. All of this would lead to a fall in investment.

Chapter nine is the concluding chapter. Lavington examines the implications of the trade cycle theory he has brought forward. He proposes two question that need to be addressed (93):

1. Are the effects on human well-being of these alternations of business activity so serious as to condemn our industrial system? 2. Whatever their importance, can they be reduced without a radical change in our present methods of industrial organization?

Lavington argues that the first question is answered by some in a very simple way: the social conditions that the industrial system produces will condemn it. Another answer would be provided by those who argue that, with all its defects, it contains „greater promise of universal material comfort than any other experiment which has preceded it“. Lavington himself is not apologetic (95-6): „If the system is to be condemned, it is not for any indifference to the problem of maximizing output, but rather for its tendency to concentrate the powers of the community too exclusively on matters of material welfare.“

Nevertheless, he lauds the system as a powerful form of organization for meeting material needs. Rich and poor alike would have seen their material welfare improve over the 19th century. That the entrepreneurs would retain a large part of the wealth they create - through the combination of resources in the production process - would be a matter of debate. Three years before the book was published, in 1919, the Top 1% fiscal income share reached a

Seite 10 von 23 maximum in the United Kingdom.12 Lavington sees a causal relation from unequal incomes to the immense accumulation of capital, apparently based on the neoclassical argument that saving finances investment. He goes on to argue that inequalities perpetuate themselves by bequest, a practice difficult to justify but also difficult to remove.

Lavington (99) notes that „the outstanding evil is unemployment“, which would constitute „an extreme irregularity in the incomes of a part of the wage-earning classes.“ Having acknowledged earlier in the book that „unwilling unemployment“ exists, Lavington asks on what principle business should be organized in order to have workers that are at the same time highly productive and reasonably content. He wonders how to reconcile collective efficiency with personal liberty. He is curious on what principle the output should be divided so that energy and thrift are stimulated without any marked inequality in incomes. He thinks about how the organization should readapt itself to adjust to changing conditions at home and abroad, without creating temporary unemployment.

Lavington believes that the remedy for the problem of cyclical unemployment must lie in modifications of the fundamental conditions of organization, of the active influences of the cycle or the conditions during the period of depression. He wonders whether some sort of collective control over resources could eliminate the influence of the cyclical movement. Believing the answer to be outside the scope of his book, he offers two comments. The first is that no rapid cure should be expected, since a time of experimentation would surely be necessary. The second comment is that the influences of the trade cycle might be modified, by making business men more fully aware of the cycle. However, even that might not be enough as it might be in the personal interest of the entrepreneur to take part in the boom though he or she perfectly knows that the boom will not last.

Lavington next turns to the method of „a more rapid readjustment cf wage and interest rates to the varying profitableness of business“. He seems to believe that if wages rose faster in the boom and fell faster in the crisis, the trade cycle would be tamed. As McCallum (1994, 167) points out, Lavington emphasizes the sluggishness in the wage nominal wage adjustment. 13This argument is again build on neoclassical theory, where employment depends on the real

12 Source: https://wid.world/share/#0/countrytimeseries/sfiinc_p99p100_z/GB/2015/eu/k/p/yearly/s/false/ 5.0264999999999995/22.5/curve/false/1895/1936

13 See Woodford (1991) for a discussion of Lavington in the context of New Keynesian Economics.

Seite 11 von 23 wage. The following proposal concerns monetary policy. Lavington (108) proposes to limit the expansion of bank loans during the boom. He believes that „an expansion in bank loans cannot increase the quantity of real resources available for production“, which is a somewhat unconvincing idea. After all, he has stated earlier that „unwilling unemployment“ exists. It is therefore not clear why an expansion of bank loans does not increase the quantity of resources that are employed.

Lavington (109) also examines fiscal policy. He writes about a plan to move a part of public expenditure from busy to dull times, such as the construction of buildings and roads. He also mentions a plan of „emergency work“, which was in operation in early 1922, and one of giving capital to „selected undertakings“ in order to support business. However, these plans would be „of the nature of palliatives“ as they would not deal with the causes behind the trade cycle. Lavington concludes the book with the following paragraph:

„But a limitation imposed on the extent of their rise, either by a further Treasury ruling removing a part of the potential expansion of note issue or a collective banking policy designed to limit the expansion of bank loans, could hardly fail to remove part of the artificial stimulus to business which results from rising prices, thereby checking the excessive growth of business confidence and limiting both the extravagance of the boom and the intensity of its following period of depression.“

3. The Great Financial Crisis and the trade cycle

The account that Lavington gives on the trade cycle builds on two crucial assumptions. The first is that the „expansion of bank balances“ leads to a rising price level. Lavington sees cumulative causation at work, but he does not make explicit whether inflation will rise ever faster once the increase in private debt is taking place. It seems that he implies that credit growth might escalate - and with it, the rate of inflation - but he does not spell it out. What we ought to see in the economy is a connection between rising total credit to the private non- financial sector and the consumer price index.

Figure 1: Growth rate of total credit to the private non-financial sector (blue) and the consumer price index (black)

Seite 12 von 23 Figure 1 shows that during recessions, which are shown by grey bars, the growth rate of total credit to the private non-financial sector falls. In the period since 1980 it fell into negative territory just once, which was during the Great Financial Crisis. The rate of inflation over the whole time period is relatively stable. However, in the years preceding the recessions of 1991, 2001 and 2009, the consumer price index started to pick up faster. The Federal Reserve Bank apparently reacted by raising its set of interest rates. This means that Lavington’s monetary mechanism of a scarcity of reserves is not at work in the modern US economy. Rather, the central bank „takes away the punch bowl“ before inflation is thought to be spiraling out of control. It does so by moving its interest rates up, which collapses private investment and then the consumer price index.

Figure 2 shows that the change in total credit to the private non-financial sector and the rate of real GDP growth correlate quite nicely. Lavington’s theory that an „expansion of bank balances“ leads to a rising level of economic activity seems to be supported by a look at the data. Private credit growth seems to be roughly double of real GDP growth when looking at 1980 to the Great Financial Crisis. Since 2008, this has changed. Now private credit growth and the growth rate of real GDP are roughly the same. Possibly this is a consequence of private sector de-leveraging and higher government spending in the aftermath of the Great Financial Crisis.

Figure 2: Total credit to the private non-financial sector (blue) and the growth rate of real GDP (grey) Figure 3 shows total credit to the private non-financial sector and the change of a consumer confidence indicator. Not surprisingly, confidence is falling just before a recession and in a

Seite 13 von 23 recession and rising when the economy comes out of a recession. Every time confidence fell by more than 2.5 percent in a year, a recession has followed.

Figure 3: Total credit to the private non-financial sector (blue) and the rate of change of confidence indicators of consumer (black, dashed)

4. „The trade cycle“ in economic theory

Lavington’s book contains many concepts that are familiar to scholars of the history of economic thought. The term „trade cycle“ was virtually unknown before its publication.14 Its use started to rise quickly until 1938. Afterwards, the term slowly fell into disuse. The term „business cycle“ was used in parallel, also starting its rise in the 1920s, but becoming much

14 This statement is based on research using Google’s NGram Viewer. https://books.google.com/ngrams/graph? content=trade+cycle&year_start=1800&year_end=2000&corpus=15&smoothing=0

Seite 14 von 23 more popular. Its highpoint coincided with that of the „trade cycle“, but since the 1980s the term „business cycle“ is gaining popularity while that of the „trade cycle“ is still falling.15

In the following, some of the concepts used by Lavington will be put into context by comparing them with those of Knut Wicksell, Joseph Schumpeter, John Maynard Keynes and Hyman Minsky. These economists were chosen because their work resembles in some parts that of Lavington and because all of them made somewhat of a comeback since the Great Financial Crisis. Wicksell and Schumpeter build on neoclassical foundations, Keynes and Minsky do not.

Knut Wicksell and Joseph Schumpeter

According to Boianovsky (1995, 376), „Wicksell never produced a complete and general theory of the business cycle“.16 Nevertheless, the topic was important on his research agenda. Bertil Ohlin, in the introduction to Wicksell (1936, ix), writes that for Wicksell „[t]he main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs - due above all due to organic increase in population - but is now accelerated now retarded.“ Wicksell believed that price stability could prevent crises. Monetary policy, through the variation of the rate of interest, would be responsible for achieving economic stability. As Barbaroux and Ehnts (2017, 15) point out, Wicksell (1936, 190) notes towards the end of his classic „Interest and Prices“ that the primary duty of banks is to „provide the public with a medium of exchange“. If, at low rates of interest, they cannot or will not do that then “and if they are ultimately unable to fulfil their obligations to society along the lines of private enterprise—which I very much doubt—then they would provide a worthy activity for the State.“

Boianovsky (1995, 381) provides a quote by Wicksell which makes it clear that he saw real disturbances as the driver of the trade cycle (Wicksell 1953: 67; cf. 1935: 211 and 1918: 70):

15 This is driven by the rise of real business cycle macroeconomics.

16 In the following I rely on Boianovsky’s interpretation of Wicksell.

Seite 15 von 23 „It is in the nature of things that new, great discoveries and inventions must occur sporadically, and that the resulting increase in output cannot take the form of an evenly growing stream like population growth and the increase in consumption demand. As soon as the rate of increase of output begins to lag, a hitch will immediately occur in the development of the economy. For my part ... it is in this that I discern the real source of economic fluctuations and crises.“

The sharp separation between trade cycles and crises would probably be the main feature of Wicksell’s approach, Boianovsky (1995, 400) concludes. Wicksell investigated neither psychological nor monetary causes of crises.

Schumpeter’s (1949) „Theory of Economic Development“ seems to be build on the same Marshallian foundations as those used by Lavington. There is a strong neoclassical line of thought which is extended by the creation of credit ex nihilo. Just as Lavington, Schumpeter stresses that development happens through economic cycles, which lead to creative destruction and hence development. Schumpeter (1954, 1049) in his „History of Economic Analysis“ mentions Lavington two times. He writes: „Frederick Lavington’s works are not so well known as they deserve to be: The English Capital Market (1921) and The Trade Cycle... (1922). They are unconditionally Marshallian.“

John Maynard Keynes

For John Maynard Keynes, fundamental uncertainty has always been a key issue in economics. People, among them investors and entrepreneurs, would not have a clear view of the future, so they would use probability and social conventions to guide their actions. Lawlor (2006, 171) states that Lavington and Keynes share this focus on uncertainty. Psychology plays a prominent role in the economic theory of Keynes, especially in the General Theory. Chapter fifteen, despite its title - „The Psychological and Business Incentives To Liquidity“ - is not relevant in the context of the trade cycle. The liquidity preference is discussed only later (p. 316). The appropriate chapter is chapter twenty-two: „Notes on the Trade Cycle“. In this chapter, Keynes notes that his theory should be able to explain the trade cycle. Its essential character, Keynes (1936, 313) writes, would be „mainly due to the way in which the marginal efficiency of capital fluctuates“. Since a whole book would be required to sketch it out, he provides only short notes.

Seite 16 von 23 His description of the dynamics of the cycle is similar to that of Lavington. He sees a cumulative effect at work, which would gradually lose its strength and at some point be replaced by forces operating in the opposite direction. There would be some regularity in the time-sequence and duration of the economic cycle. The crisis, a part of the cycle, would take place suddenly, whereas the upward movement comes about rather slowly. The „typical industrial trade cycle“ is caused by fluctuations in investment which are not offset by corresponding changes in the propensity to consume. Investment depends on the marginal efficiency of capital, which itself depends on „current expectations as to the future yield of capital-goods“ (315).

The explanation of the crisis would then not lie in the rise in the rate of interest, but rather in the collapse of the marginal efficiency of capital. This where Keynes parts from Lavington, who sees a rise in the interest rate as the cause behind boom turning to bust. The explanation of Keynes is „more psychological“ than the „mechanical monetary“ explanation that Lavington puts forward. In the real world, both explanations probably work together. The central bank reacts to the rise in the rate of inflation by increasing interest rates. That plus the change in expectations leads to a collapse in the marginal efficiency of capital as perceived by investors, which triggers the fall in investment.

Keynes is very explicit that a change in liquidity preference is not a cause of the crisis. The collapse in the marginal efficiency of capital would be „the essence of the situation“ that is the crisis. Keynes (1936, 316) writes: „Liquidity preference … does not increase until after the collapse in the marginal efficiency of capital.“ Keynes (ibid.) also notes that after the collapse „no practicable reduction in the rate of interest will be enough.“ This is very different from what Lavington has written about monetary policy. Laidler (1999) sees Lavington’s contribution to the theories of Keynes in the precautionary motive, as Chick (2014) has pointed out.

Lavington saw monetary policy as a policy instrument to contain the boom. Where the two agree again is the role of confidence. Keynes notes that the marginal efficiency of capital is determined „by the uncontrollable and disobedient psychology of the business world … which the economists who have put their faith in a ‚purely monetary’ remedy have underestimated“ (317). He concludes that „the duty of ordering the current volume of

Seite 17 von 23 investment cannot safely be left in private hands“ (320), finding himself in agreement with Lavington, who argues in favor of „some sort of collective control over resources“.

Whereas Lavington intends to dampen the trade cycle, Keynes argues that it would be better to abolish the slump and keep the economy permanently in a quasi-boom. He notes that apart from the War (WWI) there had been no boom so strong as to create full employment. In response to Lavington’s idea of increasing interest rates during the boom to dampen the trade cycle on the upswing Keynes states that it „cures the disease by killing the patient“ (323).

Hyman Minsky

Standing on the shoulders of both John Maynard Keynes and Joseph Schumpeter, Hyman Minsky developed his own original ideas of the economy. He was fascinated by the debt deflation of the Great Depression and inspired by Fisher’s 1933 article on the subject. He worked to add a theory of debt-inflation that would explain the upswing before the crisis. In Minsky and Vaughn (1990, 24), the Great Depression serves as a starting point. The self- interested behavior of economic units „made things worse for the macroeconomy“ instead of „promoting systemic coherence“. In the background, the collapse in aggregate demand was the cause of the crisis. Compatible with the ideas of Lavington, Minsky and Vaughn explain post-war stability to be rooted in the fact that „cash flow commitments due to liabilities were very small relative to incomes“. This connects nicely with Lavington’s statement that, if large speculative holdings financed by borrowed money would exist, pressure to sell would be high and the fall in prices steep.

Lavington’s insight that „the dangers of the situation consist simply in liabilities to pay“ is also found in Minsky’s theory. His understanding of the economy as a web of cash flow commitments starts exactly there. Lavington’s discussion of solvency of firms fits with Minsky’s theory, who always stressed financial constraints and leverage. Lavington’s idea that a rise in credit will lead to a rise in prices and that this would „justify the anticipations on which it was based“ is very close to Minsky’s idea of „validation“. Profits would validate the investment projects of the past and change the expectations regarding the safe level of debt. Lavington, like Minsky, points out that during the boom promises to pay in the future increase and that this would at some point lead to a problem.

Seite 18 von 23 Lavington, while being rooted in neoclassical thought, has perhaps opened up the road for later economists like Minsky, who focused on liabilities and cash commitments. Even though the policy conclusions are very different - Minsky argues for Big Bank and Big Government to neutralize the downturn, Lavington discards fiscal policy and argues in favor of the use of monetary policy to curb the boom - there are some theoretical parts that Minsky uses which are already present in Lavington’s book.

5. Conclusion

Lavington’s book on „The Trade Cycle“ shifted the focus of economic theory away from the concept of equilibrium. Cyclical movements were put in the forefront, cumulative processes identified to be at work. This was a shift in methodology, since writers before Lavington stressed equilibrium phenomena. Wicksell (1898) examined the economy which evolved around a natural path with a natural rate of interest. Schumpeter (1934) added credit creation to an otherwise static economy, explaining economic development as a disequilibrium process. Lavington goes beyond this and puts cyclical movements at the center of the analysis. Both Keynes and Minsky then further developed some of the ideas of Lavington, leaving behind the monetary theory based on the quantity equation, but keeping the main role that private investment plays in the trade cycle.

Applying Lavington’s theory to the case of the Great Financial Crisis in the US we see that some of the pillars of his theory still seem to be able to carry a lot of weight. It is still private investment financed by private debt that drives the trade cycle. Confidence plays a large role before and during the periods of recession, even though the evidence is not as strong as in the case of changes in net private debt and real GDP growth. Last but not least, rising prices do matter for cumulative processes and these cumulative processes are clearly at work. It is in his monetary theory where Lavington errs. Bank deposits are not leveraged up on central bank deposits, as the theory of fractional reserve banking supposes.17 In the real world, the interest rate does not go up during the boom because of an increase in the demand for cash imposes scarcity of money. Rather, the central bank increases the set of interest rates under its control when it fears that the rate of inflation will spiral out of control.

17 This has been pointed out by authors like Wray (2014).

Seite 19 von 23 Lavington’s book has provided us with some innovative building blocks that can be used to re-examine what we do in modern macroeconomics, which has again fallen back to the use of the concept of equilibrium. His focus on investment and credit expansion, on debt commitments and the price level have been mirrored by authors like Keynes and Minsky, but also Schumpeter. Where Lavington falls short is in the field of economic policy. Writing only years before the Great Depression, the belief that the market system would be guided by an invisible hand to provide full employment was probably still too strong.

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