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.