Money, Interest, And The Business Cycle

In answering this question, we are also answering a question that has occupied people for decades, even centuries in some countries that have had central banks and a system of credit expansion. This is the problem of the trade cycle—the regular return of periods of economic depression. In Great Britain from the end of the eighteenth century on, and later in those countries of the world that entered step by step into the system of modern capitalism and modern banking methods, we could observe from time to time an almost regular occurrence of events, i.e., the emergence of periods of economic depression, economic crises. We do not mean economic crises brought about by some obvious event that makes it possible to explain the emergence of this crisis. For instance, in the early 1860s the American Civil War made it impossible to ship cotton from the United States to Europe; and the U.S. Southern states were at that time the only suppliers of cotton to Europe. There was a very bad economic crisis, starting in the cotton-goods industries in Europe and as a consequence other industries suffered also. But everyone realized what was causing this crisis—it was the American Civil War and the stoppage of shipments of cotton to Europe. We do not deal with such crises due to a definite identifiable situation. We deal with a genuine crisis in all branches of business—although it is sometimes worse in some branches than in others—a crisis for which people couldn’t see any special reason.

From the beginning of the nineteenth century on, people began to consider these periodic crises as one of the most important problems of economic research. In the 1830s and 1840s British economists answered this question by saying, “What we have to study is not the economic depression. This depression is always the consequence of a preceding boom. We must ask ourselves not ‘What is the cause of the crisis?’—we must ask ‘What is the cause of the preceding boom?’ And we must ask ourselves what is the reason why the unquestionable and certain development of economic conditions that takes place in all countries with capitalism does not proceed steadily upward, but follows a wave-like movement, a movement in which there are repeated boom periods that always are followed by periods of depression.” In this way the crisis problem was transformed into the problem of the trade cycle. And for the problem of the trade cycle many more or less wrong explanations were offered.

I want to mention only one. This was the doctrine of an otherwise famous economist, William Stanley Jevons [1835–82]. His doctrine acquired some fame. He attributed economic crises to sunspots. He said that sunspots bring about bad harvests, and this means bad business. If this was so, why then didn’t business adjust to this natural phenomenon as it learned to adjust to other natural phenomena?

If there is credit expansion, it must necessarily lower the rate of interest. If the banks are to find borrowers for additional credit, they must lower the rate of interest or lower the credit qualifications of would-be borrowers. Because all those who wanted loans at the previous rate of interest had gotten them, the banks must either offer loans at a lower interest rate or include in the class of businesses to whom loans are granted at the previous rate less-promising businesses, people of lower credit quality.

When individuals consume less than they produce, the surplus production is set aside as savings. Thus when the money given out in loans comes from savers, it represents actual goods which are available for further production. But when the loans are granted out of credit expansion, businessmen are misled; there are no goods standing behind them, only newly created credit. This leads to a falsification of economic calculation. Credit expansion brings about a systematic falsification—it gives to the individual businessman the impression that a project that couldn’t be executed yesterday because there were not enough capital goods, can now be executed on account of the credit expansion. As a result, there is an intensification of business activity, which means that higher prices are offered for the factors of production. But there has been no increase in the quantity of capital goods. Therefore the intensification of business activity means an artificial boom. Producers of factors of production are happy when they see that the prices they are getting are higher than they were yesterday. But this cannot go on forever, because no more material factors of production have been produced. The prices of these factors of production are going up more and more as borrowers of the new credit compete and bid up their prices. Then finally two alternatives are possible.

Business is asking for more and more credit. Either (1) the banks grant this demand by creating more and more credit (this happened in Germany in 1923, when it led to a complete breakdown of the currency). Or (2) one day, because they realize for some reason or other that they must stop credit expansion, the banks do stop creating new credit to lend. Then the firms that have expanded cannot get credit to pay for the factors of production necessary for the completion of the investment projects which they have already committed themselves. Because they cannot pay their bills, they sell off their inventories cheap. Then comes the panic, the breakdown. And the depression starts.

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This essay is a selection from lecture 7 in Marxism Unmasked: From Delusion to Destruction.

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