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years. Thus is established the dependence of all the complex phenomena of economic cycles upon the simple underlying phenomenon of the meteorological cycle.

122. Capitalization and Crises29

BY FRANK A. FETTER

Capitalization runs through all industry. The value of everything that lasts for more than a moment is built in part upon income which is not actual, but expectative, whose amount, therefore, is a matter of guesswork, or speculation. Many unknown factors enter into the estimate of future incomes. The universal tendency to rhythm in motion manifests itself in an overestimate or underestimate of income. Most men follow a leader in investment as in other things. The spirit of speculation grows until it becomes almost a frenzy and people rush toward this or that investment, throwing capitalization in some industries far out of equilibrium with that in others.

The use of credit enhances the rhythm of price. A large part of business is done on margins. If the value of a thing fully paid for falls in the hands of the owner, he alone loses; but, if the value of a thing only partially paid for falls so much that the owner is forced to default in his payment, the loss may be transmitted along the line of credit to every one in the series of transactions. credit system, highly developed, is a house of cards at a time of financial stress. There is an element of credit in almost all business. Entrepreneurs enter into strenuous rivalry to secure the profits of a rise, ever hoping to get out whole before the crisis

comes.

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The fundamental cause of crises thus is seen to be psychological; it is the rhythmic miscalculation of incomes and of capital value, occurring to some degree throughout industry. This is given full opportunity for action only when certain favoring objective conditions are present. Most noteworthy of these is the dynamic condition of industry. The past century has opened up new fields of investment on an unexampled scale. New machinery and processes have given undreamed of opportunity for enterprise. Such factors disturb the equilibrium of prices both in time and space, give a powerful stimulus towards higher values, and stimulate the hopes of all investors. When the balance between the capitalization of

29

20 Adapted from Principles of Economics, 353-354. Copyright by the Century Co. (1904).

various industries and between the income of various periods proves to be false, the inevitable readjustment causes suffering and, loss to many, but particularly in the inflated industries. But, because of the mutual relations of men in business, few even of those who have kept freest from speculation can quite escape the evils.

123. The Lagging Adjustment of Interest3°

BY IRVING FISHER

Few persons realize how central a rôle interest plays in all business phenomena. Interest is the link connecting each year with the next. Every plan and contract involving time must be made. partly in terms of the rate of interest, even though this rate enters unperceived. We have several billions of dollars invested today in the life insurance business. The whole structure has been calculated by assuming a law of human mortality and a rate of interest. A change of one point in the rate of interest makes an enormous change in all these calculations. The value of all lands, all capital, all securities, depends upon the rate of interest. The importance, therefore, of having the rate properly adjusted cannot be too much emphasized. To show the necessity of an adjustment to meet a new situation let us take an example. If in 1896 it had been believed that Bryan was to be elected, that his program was to be carried out, and that in consequence there was to be enacted a veritable "50-cent dollar," it would have been necessary to increase the rate of interest by an amount equal to a sinking fund for the 50 per cent depreciation. In like manner it is always necessary for self-protection to raise the interest rate to guard against any foreseen depreciation.

To offset such depreciation the business man does not actually have to call it by that name. Instead of considering gold as changing in value, he may consider commodities as changing in terms of gold; and instead of talking of depreciation of gold, he may speak of rise of prices. The business man who believes that prices in general will rise in the next ten years believes in effect that the value of gold will fall. He will be likely to take this fact into account in connection with every business venture or investment. The result will inevitably be a rise in the rate of interest. If, for instance, he is a borrower, rising prices will mean to him rising profits, and he will be much more ready than if prices were falling to pay high interest. On the other hand, to be tempted to lend money, he will require higher interest to insure his receiving an equivalent of the purchasing.

30 Adapted from "Gold Depreciation and Interest Rates," in Moody's Magazine, VII, 110-114. Copyright (1909).

power loaned. There is thus provided a certain escape from the evils attending a foreknown change in the value of money.

Unfortunately, however, the great mass of persons do not consider the prospect of a change in the general level of prices. An investigation seeking to determine to what extent a rise in prices is actually discounted and offset shows: first, that in general when prices are rising, the rate of interest is high and therefore does to a certain extent compensate for the fall in the principal, but second, it is not usually high enough fully to compensate for this depreciation. In other words, it is only partially adjusted.

This lack of adjustment implies a transfer of the ownership of wealth from the creditor to the debtor. The investor who is shrewd enough to foresee the rise in prices will bond his business at the current rate of interest. Since this rate is lower than his business could afford to pay, the enterpriser wins at the expense of the bondholder. He will borrow more than he otherwise would because the rate of interest is lower than it should be. The borrowing class today consists of the enterprisers-precisely the men who have the greatest foresight-consequently it is the borrower, not the lender, who first foresees a rise or fall of prices. If the lender foresaw equally he would demand a higher rate of interest when prices are rising. An adequate adjustment of interest would prevent this extensive borrowing, but, because of an inequality of foresight, a rise of prices will stimulate loans.

This is the analysis of the universally observed fact that during a period of rising prices loans are unduly stimulated. For a time. larger profits are made simply because part of the lender's share goes to the borrower, and this continues until the rate of interest at last becomes sufficiently adjusted to check the loans.

A crisis is the cumulation of a period of rising prices. In the mechanism of this process, however, the main rôle is played by the rate of interest. The series of events is, I believe, in general as follows:

First, a rise in prices through any cause, such as an increased production of gold.

Second, failure at first of the rate of interest to rise enough to offset the impending fall in the value of money (rise in prices). Third, borrowers are quicker to grasp the situation than lenders, and consequently loans are unduly extended.

Fourth, the increase of loans is accompanied by an increase of bank deposits.

Fifth, since bank deposits act as a substitute for money, an increase of bank deposits tends further to increase prices.

In other words, as a result of this chain of causes, beginning with a rise in prices, the prices will rise still further. There is thus set up a vicious circle, which will continue just as long as the rate of interest fails to make a proper adjustment to put on the brakes and prevent the over-borrowing. It is odd that when the crisis comes the blame is put on the high rate of interest, in utter disregard of the fact that if the rate of interest had been higher at first, the crisis would have been averted.

H. CREDIT AND CRISES

124 Inelasticity of Credit under the National Banking System

BY HAROLD G. MOULTON

The financial crisis is marked by an enormous demand upon the banks for funds. Many business men, finding that debts due them are not being paid at maturity, become, in consequence, unable to meet their own maturing obligations. The result is a rush to the banks for loans with which to tide themselves over the crisis. Many other business men, who merely fear that their debtors may not be able to pay promptly, also rush to the banks for an accommodation in anticipation of trouble to come. It is usually feared that a little later loans may be procured only at a very high rate, if at all; and that, in any event, an immediate loan insures financial safety and peace of mind to the worried business man.

Under the recently superseded national banking system, sound banking practice, as well as the law, required national banks to keep a reserve in cash against their obligations which were payable on demand. For instance, in the big financial centers, a reserve of 25 per cent was required. That is, if the bank had made loans to the extent of $1,000,000 and had given depositors checking (deposit) accounts against which they might draw as desired, it would have to hold in cash a reserve of at least $250,000. To illustrate the situation. that develops in time of crisis, let us assume the above bank to have a reserve of $275,000, or 27.5 per cent, and that at the time of crisis there arises a demand for $100,000 of additional loans to business. This would make the deposit accounts equal to substantially $1,100,ooo, without causing any change in the reserve; and the result would be a reduction in percentage of reserves to deposits from 27.5 to 25

per cent, the legal minimum. The situation is usually rendered still more acute by reason of the fact that many depositors, fearful of the safety of the banks, withdraw and hoard cash. If we assume $50,000 to be withdrawn in this way, the reserve is reduced to $225,000 which, of course, further reduces the ratio of reserve to deposits, specifically to about 21.5 per cent. This double strain upon the banks thus quickly carries them to a point where inability to maintain specie payments and consequently insolvency is imminent. Thus far we have spoken of a demand on the banks for funds or loans, using these terms in a general sense. It is now necessary to clarify the situation by stating that the demand of the business world is partly for credit in the form of checking accounts, and partly for actual money in the form of bank notes. The latter appears to the average person as the all-important, if not the sole, function. Scarcity of money is what the man of small means whose transactions are generally of a retail nature sees. This is of course a scarcity of available funds due to the hoarding that has taken place; but a scarcity of credit, of the ability to procure checking accounts which can be drawn against in making payments, is of far greater moment. The total demand for deposit or check currency is many times as great as the demand for money or bank-note currency.

Under the national banking system it was practically impossible for the banks to expand materially either their note issues or their deposit currency in time of crisis. To issue notes a bank had first to expend cash to a greater amount in the purchase of government bonds to secure the value of the notes to be issued. Moreover, it was usually extremely difficult to secure the bonds required. The note issue, accordingly, was very inelastic.

While deposit currency could be expanded as long as the reserves were plentiful, the necessary expansion incident to the crisis could not be met. Replenishment of reserves is absolutely essential to an extensive expansion of deposit currency. But the banks were unable to increase their reserves. Normally a bank might be expected to do in time of stress what an individual does, namely, sell or pledge as security for a loan more of its available assets or property. But, except in a limited way through the agency of clearing-house associations, there was no means by which the banks could convert their assets into cash. Our national banking system was decentralized and non-co-operative; and in time of trouble each bank endeavored to save itself regardless of others, with the devil taking the hindmost. There was no central agency or institution to which banks that were hardpressed could turn for accommodation. Credit or deposit currency was therefore almost as inelastic as bank-note currency.

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