HB 3716 .H5 Copy 1 Business Cycles By WARREN F. HICKERNELL, Ph.D. Director, Bureau of Business Conditions, Alexander Hamilton Institute. Lecturer on "Panics and Depressions," School of Com- merce, Accounts and Finance, New York University. Formerly Mana£in& Editor, Brookmire Economic Service. Author, "Methods of Business Forecasting" and Numerous Articles on Finance. AMERICAN INSTITUTE OF FINANCE Business Cycles By WARREN F. HICKERNELL, Ph.D. Director, Bureau of Business Conditions, Alexander Hamilton Institute. Lecturer on "Panics and Depressions," School of Com- merce, Accounts and Finance, New York University. Formerly Mana£in& Editor, Brookmire Economic Service. Author, "Methods of Business Forecasting" and Numerous Articles on Finance. AMERICAN INSTITUTE OF FINANCE BOSTON c c n Copyright, 1922, by American Institute of Finance DCU695743 Ms TABLE OF CONTENTS Pake Chapter I. The Cycle Described Periods of the Cycle 5 Description of the Cycle 5 Reaction and Depression 6 What Our Problem Is 7 Chapter II. Outlining the Problem Meeting Friendly Skepticism 8 Why Should Cycles be Understood ? 8 Intuition vs. Sound Judgment 9 Developing a Correct Method 10 Chapter III. Selecting an Index of the Business Cycle. What the Term "Cycle" Means 11 Statistical Indexes 12 Bank Clearings — A Good Index 13 Imports and Exports ' 14 Commodity Prices 15 Miscellaneous Indexes of Business Conditions 16 Charting Cycle Indexes 17 Corrected Cycle Indexes 17 Chapter IV. The Normal Cycle Normal Cycle Defined 20 Cause of the Normal Cycle 20 Loanable Funds 21 Normal Condition of a Central Bank 21 Expanded Credit Position (Gold assumed stationary) .... 22 Expanded Credit Position (Gold reduced) 22 International Influences 22 Increasing the Gold Reserves 23 Credit Deflated; Loanable Funds Abundant 24 Cause and Effect 24 New York Financial Barometers 25 Conditions 1904-08 26 Barometers of European Financial Conditions 27 4 Table of Contents Pafee Chapter IV. The Normal Cycle {continued) After- War Barometers 29 Principle Restated 30 Practical Application of the Scientific Method 30 What Scientific Method Means 31 Summary of Chapter 32 Chapter V. The "Cross-Currents" Cross-Currents of Two Kinds 33 Gold Production 33 Test of Degree of Gold Production 34 Inconvertible Paper Money 35 Unsound Bank Management 36 Crops 36 Historical Verification the Next Step 37 Chapter VI. Resume of History of Panics Chief Panics, 1720-1920 38-44 Watching the Trend of Affairs 44 CHAPTER I THE CYCLE DESCRIBED Periods of the Cycle The stages of the business cycle are sometimes described by dividing the trend of business conditions into four periods: 1. Business improvement — wages and profits rising. 2. Business prosperity — incomes at high tide. 3. Business reaction — incomes declining. 4. Business depression — incomes at low level. Description of the Cycle First Period. At the beginning of a cycle the chief features of the situation are low interest rates, a buoyant bond market, a slow demand for labor, dullness in trade and a low level of com- modity prices. The active market for bonds stimulates new construction work. It is good business to carry out plans for permanent construction when long-term bonds can be sold at a low rate of interest, insuring a small fixed charge over a long period. There is an expansion of demand for iron and steel and other construction materials. The payrolls of factories and construction companies grow rapidly. The broader wage disbursements lead to heavier purchases of clothing and furni- ture. Second Period. Presently, business improvement grows into pronounced prosperity. Activity becomes feverish in this period. But higher prices and enlarged trade require expansion of bank loans. When prosperity reaches the point where the credit required to finance trade exceeds the supply of loanable banking funds, the insistent bidding for funds by merchants' forces interest rates to an abnormally high level. Moreover, to provide adequate loans to merchants, the banks reduce loans 6 Business Cycles on stocks and bonds. This shifting process is a danger sign in the stock market. The high interest rates and restricted security loans kill the sale of bonds; the interest rate offered on new bonds must com- pete with the current market rate. Corporations are loath to issue new bonds at sacrifice prices and postpone plans for new construction work. Orders for steel for future delivery fall off, and likewise for other commodities. When the demand for goods for future delivery falls below the productive capacity at the existing price level, there is a crisis. The first half of the cycle is over. The crisis marks the transition from the second to the third period of the cycle. Reaction and Depression Third Period. The second half of the cycle, comprising the course of Reaction and Depression, is a reversal of the first half. After the crisis, demand falls rapidly. In order to avoid com- plete idleness, sellers of goods are forced to lower prices to effect distribution. Old debts are paid off. New commitments are made at reduced prices, so that replacements require less credit. Commercial loans are cut down. The banks accumulate a loanable surplus. Fourth Period. In order to employ their surplus funds, the banks reduce interest rates. But they are unable to find a demand for short time commercial loans among merchants and manufacturers sufficient to absorb their surplus, even at low discount rates. They therefore lend freely upon bonds at in- terest rates lower than the income yield obtainable from bonds. This naturally stimulates active buying of bonds. There is an active bond market, and large corporations plan for future ex- pansion. This situation marks the end of the cycle. It is the situation described above as marking the beginning of a new cycle. Two factors which can usually be depended on to assist re- covery during depression are an increase in gold production and a growth of efficiency in productive and inventive processes. The Cycle D escrib ed 7 Gold mining becomes more profitable when low prices reduce mining costs with the selling price of gold remaining constant. Greater attention is given to the productive and inventive processes owing to stagnation in the speculative markets. Labor moves from the cities to the country in some measure when manufacturing becomes dull and this promotes agricultural in- dustry. The latter is also strengthened by the fact that farmers work more soberly after a financial crisis. Land specu- lation declines, and as hopes of becoming rich through rising values vanish, more attention is given to production. What Our Problem Is We shall take up the analysis of the cycle from the stand- point of stock market fluctuations in a later Text — "The Search for Bargains"- — showing how stock market buying and selling policy should change in the different periods of the business cycle. In the present Text we shall discuss how the general trend of each cycle is determined by a dependable principle, and that business forecasting may be reduced to a formula, which, even though not mathematically exact, is measurably scientific in nature and helpfully systematic. CHAPTER II OUTLINING THE PROBLEM Meeting Friendly Skepticism A master among university scholars of the past generation habitually challenged the originator of an academic thesis with the questions: What have you got? How do you know it? What of it? Such questions are frequently raised regarding the subject of business cycles. One prominent authority on the subject, after an exhaustive investigation, even suggests that perhaps the students of each succeeding generation will find it necessary to revise the theory of business cycles accepted by the preceding generation. We find, also, that experienced business men some- times exhibit skepticism regarding the possibility of forecasting business conditions according to a theory of business cycles. Some of them believe that there are too many cross-currents in any given business situation to make it feasible to follow a sys- tematic method of judging the future trend of business. This attitude of skepticism, of course, is not wholly surpris- ing. It is true that fluctuations become irregular at times owing to apparently unforeseeable accidents or disturbing cross-currents. Why Should Cycles be Understood ? The fact that disturbing influences are always rising to con- fuse and perplex us in managing our financial affairs, however, is all the more reason why we should seek a systematic method of forecasting which will enable us to look ahead with positive opinion and a definite policy during periods of financial unsettle- ment. If confusion and uncertainty can be reduced to a nego- tiable minimum, that is a thing worth while. Outlining the Problem 9 But there are more positive and more convincing reasons for seeking a definite plan of judging the future according to a theory of business cycles. The first is that the history of the past century shows that prices and incomes have fluctuated up and down in never-ending process. The study of the subject is compulsory. It is impossible to avoid the ups and downs of the cycle. The second is that fortunes can be built up more quickly by taking advantage of the rising tide of the cycle than by any other method. And they can be lost suddenly when the trend turns downward. Even professional speculators achieve success only when they make their commitments with due regard for the underlying trend of the cycle. Those who operate merely by intuition eventually "go broke." Probably more than half of the investors who were owners of speculative stocks during the six-month period from October, 1919, to March, 1920 — perhaps over eighty per cent of them — were entirely unpre- pared for the drastic declines in prices which actually occurred in November and February, although, to those acquainted with the method of judging the trend of the cycle explained in the following pages, the signs of a coming slump were clearly in evidence months in advance. To depend entirely upon intui- tion is not a satisfactory plan. Intuition vs. Sound Judgment The history of the past one hundred years shows that the big swings of the cycle, though never exactly similar in different periods, are governed in each case by certain underlying prin- ciples. These principles it is possible to know and to use with profit at all times. It is agreed that exceptional circumstances are always present, and that individual judgment, based upon experience, is always necessary in estimating the influence of the cross-currents which cause irregularities in fluctuations. The conditions affecting trade and finance are complex, but the for- mulation of a plan of forecasting business conditions with some claim to scientific method is not difficult, provided we develop our method one step at a time. 10 Business Cycles Developing a Correct Method The process of developing this method must be divided into three distinct departments. These divisions of study are as follows : 1. Defining and picturing the business cycle. What statis- tical indexes can we follow in order to enable us to ob- serve whether a given point in the cycle is above or below normal? 2. The dependable cause of the "normal cycle." What principal or law is always operative in every cycle, causing prosperity to develop after depression and making it certain that a crisis and a period of depression must follow every period of prosperity? And what barometers guide us in anticipating conditions? 3. The cross-currents which cause irregularity. What are the forces which disturb the normal curve of the cycle and prevent different cycles from being alike? What have been the principal cross-currents during the past century, and which of these are likely to require our attention in the next ten, twenty or fifty years? As the first step, let us now proceed to consider the business cycle, its definition and graphic representation. CHAPTER III SELECTING AN INDEX OF THE BUSINESS CYCLE What the Term "Cycle" Means Two problems concern us in this chapter. First, what con- cept do we have in mind when we use the phrase, "business cycle"? Second, what statistical indexes picture the fluctuations of the cycle? Some students of the subject with whom I have talked con- sider business cycles to be "price cycles." To them, a cycle of conditions in the steel industry would be depicted by a chart showing an oscillation of the prices of iron and steel. Similarly, a cycle in the oil industry would be indicated by a rise and fall in the price of petroleum. A cycle of general business would be indicated by a cycle of commodity prices as reflected, for in- stance, in an oscillation of Bradstreet's index. Other students prefer to place emphasis upon production. They are interested in the physical volume of trade. A cycle in the steel and iron industry to them would be pictured in the monthly statistics of pig iron production or deliveries of finished steel. Taking business as a whole they would be more inter- ested in the aggregate tonnage of merchandise produced and delivered for consumption than in the trendy of Bradstreet's index of commodity prices. Personally, however, when I think of the trend of the busi- ness cycle, I am not satisfied with either of these methods of charting its fluctuations. It is true, of course, that a well- informed man should know whether production is increasing or decreasing, and also whether prices are rising or falling. He should study business in all of its departments. In the actual work of forecasting business conditions, however, I believe the most profitable concept is to think of the cycle as an oscilla- tion of the "income stream" of the community as a whole. 12 Business Cycles Prosperity depends upon the purchasing power of all classes of people in every line of business. The incomes of particular groups of people or lines of industry may be temporarily de- pressed while the incomes of the rest of the community are in- creasing enough to cause general expansion in the demand for goods. In constructing a chart of the business cycle, therefore, we should arrive at something which will show us the ebb and flow of the total income, or "spending power," of the whole community. For practical purposes income and spending power mean the same thing. People spend all they get, directly or indirectly. That part of income which is saved is deposited in the banks, where it is loaned to purchasers of goods. Statistical Indexes Having defined the business cycle as the upswing and down- swing of the income or spending power of the community, let us seek a statistical compass, or chart, of the cycle. If we de- sire to chart the income of the steel industry, we must first multiply the tonnage produced by the average selling prices. For instance let us suppose that in one year the output of finished steel in the United States was 28,000,000 tons and the average selling price $50 a ton. The total value would be $1,400,000,000. Then suppose that in the next year the total output was 33,000,000 tons and the average selling price $100 a ton. The total value would rise to $3,300,000,000. Note that the price is doubled, but the value is more than doubled. The total value of the product represents the aggregate income of everybody employed in the steel industry. It measures their spending power. It also covers dividends and taxes and provides spending power to stockholders and government employees. But suppose the next year's production declines to 30,000,000 tons and prices to an average of $40 a ton. The total value falls to $1,200,000,000. Obviously the spending power would decrease, for this figure indicates a decline in the gross revenue available for wages, salaries and dividends. Now, if all other industries showed proportional fluctuations in prices and production, we might take these statistics of the Selecting an Index 13 steel industry as a faithful index of the trend of general business. But is this permissible? Perhaps incomes in other industries do not rise and fall in proportion. The total gross earnings in the oil, motor, copper and transportation industries might show a different trend. To be on the safe side we should try to think of business cycles as representing the tips and downs in the total spending power of the whole community, including professional men, bankers, brokers and merchants as well as the wage- earners in the basic industries. Bank Clearings — A Good Index Let us now proceed toward a selection of statistical indexes which will serve us in showing the trend of the cycle. If the cycle represents changes in spending power, we should first attempt to gather statistics of all the bank checks signed by the public and used to pay for goods bought from month to month. Fortunately, we have very satisfactory statistics of what the public does in the way of paying its bills. The "Financial Chronicle" at the end of every month publishes statistics of bank clearings which represent all the checks exchanged between banks in their daily settlements. Sometimes, of course, both the buyer and the seller in a given transaction use the same bank. In that -case the check is not sent to the clearing house. Then, too, many checks are cleared at the Federal Reserve Banks. Statistics of bank clearings, therefore, do not cover the total transactions of the community. On the other hand, some transactions reflected in clearings do not represent spending power. A good many wealthy capi- talists and speculators buy huge amounts of goods, not for consumption, but to sell at a profit at an early date. The checks signed by such men represent many times their income. They continue paying out and receiving back practically the same money every week in the year, without buying and keeping anything to speak of. They merely speculate. Their transac- tions represent a rapid turn-over in their capital, not a true index of their incomes. This is particularly true of stock specu- lators in Wall Street. In fact, bank clearings in New York 14 Business Cycles City reflect speculation more than the true trend of spending for consumption. Let us state, however, that we do not care if the aggregate of bank clearings does not exactly equal the total spending power. We are interested in the trend of fluctuations and not in calculating statistical volumes, and, for our purpose, the per cent of increase or decrease in bank clearings is more important than the amount per capita. Let us conclude our discussion of bank clearings with the opinion that they are one of the best indexes of the fluctuations in the total income and therefore in the total spending power of the whole community. Imports and Exports As an index of the business cycle, statistics of "merchandise imports" have several points of merit. They represent the trend of the prices of the goods which a country is buying for consumption from foreign countries. By analyzing imports we can see whether raw materials or foodstuffs are coming from abroad in larger or smaller volume. The monthly reports of the country's imports are of continual interest to the student of Panics and Depressions. An especial quality of imports is that they are an index of commodity prices, automatically weighted according to the quantity of each commodity purchased from abroad. Similarly, merchandise exports are also a weighted price index. They show the trend of prices of the surplus products of a country, and therefore reflect internal economic strength or weakness. As indexes of the business cycle, however, statistics of ex- ports and imports have one defect. In case a country is block- aded during war time, foreign trade falls to a low level. The statistics of imports and exports in that case do not tell us the true tendency of the country's national income, or total spending power. It should also be noted that, as indexes, imports and exports differ slightly. When exports rise, it may mean that the country is shipping goods to pay debts abroad, whereas if imports are Selecting an 1 71 dex 15 temporarily abnormal, extravagance in the consumption of foreign goods may be indicated, and presumably the importing country is getting badly into debt. In the stress of a financial crisis, a country which has been getting badly into debt becomes embarrassed, while a country which has been selling its goods abroad and building up a strong foreign credit balance may come through the panic period with little disturbance in the money market. In the long run, imports and exports are good indexes of the business cycle, but it is necessary to observe the qualifications above stated. Commodity Prices An average of the prices of important commodities is ordin- arily a good index of the business cycle. The wages and profits in any industry must be covered by sale prices, and an average of the prices in all basic industries indicates the trend of the gross income of business in general. One defect of commodity prices as an index is that they tend to seek an international equilibrium, so that the fluctuations are pretty much the same in all countries on a gold monetary basis. Because of this international similarity, fluctuations of prices do not reflect important differences in financial conditions in dif- ferent countries. If we desire to ascertain how any one coun- try is situated at the time of a financial crisis, therefore, it is necessary to study other statistical indexes which have a local color. At the present time, of course, because of the suspension of gold payment in the largest European countries, it can truly be said that indexes of commodity prices in most of the large foreign countries do reflect local conditions. Until gold payment is resumed in England and France, the commodity price indexes of these countries, as well as sterling and franc quotations, will serve to guide us in noting the progress being made toward deflation. 16 Business Cycles Miscellaneous Indexes of Business Conditions Under this topic we shall mention a number of statistical guides which every man should keep in touch with for their in- dividual significance rather than as indexes of the cycle of com- munity income. Such indexes are pig iron production, unfilled steel orders, commercial failures, immigration, and building permits. Pig iron production is defective because it reflects only the physical volume of trade and not the aggregate money income of the country. Moreover, it reflects conditions in a particular industry and sometimes may not indicate the prosperity of the entire community. The same applies to unfilled steel orders. But the iron and steel industry is so important that it deserves special and constant consideration. Commercial failures move inversely with a country's pros- perity. When commodity prices decline, failures increase. Re- versely, when prices rise, failures fall to a low level. The chief defect of failures as a guide to prosperity is that they are a little slow in coming to our observation. Such statistical indexes as bank clearings, commodity prices and foreign trade are some- what more prompt in suggesting the cycle's trend. The lia- bilities involved in failures, however, would seem, theoretically, to be a good inverse index of the trend of community income. Immigration is not an especially good index of business con- ditions. During the European war, statistics of immigration did not indicate the general trend of the total income, or spending power, of the United States. But although they are not a good index of the business cycle, we should study immigration statis- tics in relation to the supply of common labor. As a sidelight they are interesting. Building permits have a bearing upon the amount of new building in prospect. They rise early in the cycle. Like stock market sales, the volume of bond sales and reports of new issues of securities, they foreshadow the future tendency of business. They precede the changes in the general prosperity of the coun- try rather than reflect the current trend of incomes. Selecting an I n dex 17 Charting Cycle Indexes The student of charts is confronted with two confusing ele- ments in attempting to judge the position of the business cycle from a graph of "actual statistics." The true trend of the busi- ness cycle is partially obscured owing to seasonal tendencies and the general upward drift commonly known as "normal growth." Statisticians, speaking professionally, call this growth the "secu- lar trend." There are a number of ways of eliminating seasonal variation and normal growth. One method is to eliminate the seasonal variation separately and then "step down" the normal growth. A second method is to divide any one month by an average of that same month for a number of years preceding. Corrected Cycle Indexes In the following diagram of Imports we have employed a simple method of eliminating the seasonal and the secular ten- dencies, the "cyclical curve" being shown by the heavy line. It is clear that this corrected line is a better guide than the graph of actual imports (the light broken line). We might go a step further and average the above "cyclical curve" of imports with similar corrected graphs of clearings, commodity prices and several other cycle indexes, arriving at a single, composite business Index. This combining process may be objectionable to those who wish to study the individual sig- nificance of each index, but it has the advantage of concentrating our thought upon the idea involved, namely, that a business index should represent the fluctuations in the aggregate income, or spending poiver, of the community. We have stated above that bank clearings, foreign trade statistics and commodity prices are probably the best indexes of the trend of general prosperity. In the United States, how- ever, it is permissible to include pig iron production and pig iron prices, and also unfilled steel orders, because the iron and steel business is a basic industry and has the special significance of reflecting the trend of new construction work. Perhaps statistics of bank clearings and foreign trade alone might answer 18 Business Cycles our purpose just as well as an average of six or eight items. However, if the secondary items are interesting in themselves, there is no objection to averaging them into a single Business Index, which might well be called an Index of Income, because Mdse. imports , udr Actual and Corrected Statistics on Imports The above chart shows that before the war the rate of interest in London and the Bank of France's ratio of cash to note circulation were important barometers for the speculator operating in Wall Street. These barometers will again be important when London resumes the gold standard of payment in business transactions. But for several years ahead the reserve ratio of our Federal Reserve Banks and time money rates in New York will probably deserve prime consideration. We are not independent of European influences, but we are now more self-sufficient in our finances than before the war and Europe looks to us for aid, whereas before the war we borrowed large amounts ftom Europe. Selecting an Index 19 it represents the curve of the aggregate wages and profits of the community during the course of the business cycle. For an example of an index of General Business, or General Community Income, the reader is referred to in the Text, "Measuring and Forecasting Business Conditions," where the subject of combining statistical graphs into one composite index is dealt with con- structively by Professor Persons. Having now pointed out the specific indexes which guide us in observing the general direction of the cycle, the work in this chapter has been completed. A more important subject is now ahead of us, viz., what causes the fluctuations of the business cycle? In raising this question, we suddenly realize that the above chart does not forecast anything. It merely reveals whether business is above or below normal. The most impor- tant consideration now is to arrive at a method of predicting whether at any time the business index will ascend or descend. CHAPTER IV THE NORMAL CYCLE Normal Cycle Defined What is the "Normal Cycle"? In actual experience no cycle is normal. Accidents always happen to disturb the normal trend. Nevertheless, there always is an underlying trend, and the idea of a normal cycle has a very practical value in helping us look beyond the temporary periods of irregularity. Let us regard the normal cycle as consisting of fluctuations above and below a horizontal normal line, the second half of the cycle declining exactly in proportion to the forward move- ment of the first half, and the area of prosperity above the normal line being exactly equalled by the period of depression which develops below the line. In every cycle such a condition of regularity would develop if it were not for the accidental cross-currents which disturb the normal trend. Cause of the Normal Cycle The underlying trend of every cycle — the normal trend — is caused by a single factor. This factor is the flow of the loanable funds of the banks, to and from the borrowers in a community. When loanable funds are abundant, they are freely lent. The borrowers disburse them for merchandise and wages. The flow of funds from lenders to borrowers leads directly to rising prices and higher wages. Reversely, when bank credit is over-extended and lenders exact higher interest rates, borrowing is discouraged. There is a general slackening in the transfer of loanable funds from lender to borrower. The borrower reduces purchases of commodities and curtails employment. The Normal Cycle 21 Our method of forecasting the business cycle is simplified if we start with this simple explanation of the cause of the normal cycle. Free lending breeds prosperity. Depression results from restriction of credit. To forecast the underlying direction of the cycle it is only necessary to ask and answer the two fol- lowing questions: 1. Can commercial loans expand further? If so, the normal trend of the cycle is still upward. 2. Must commercial loans be restricted? If so, the normal trend of the cycle will turn downward. Loanable Funds Our starting point in the study of loanable funds is the state- ment that in normal times the central banks in the money centres of the world, especially London, Paris, and New York, should keep about half of their assets in gold. As a guiding principle we may say that when their assets are half gold and half interest- bearing paper, they are in normal condition. Let us picture this condition in a table showing the two principal items of a central bank. Normal Condition of a Central Bank Loans $2,000,000,000 50% Go l d ....'... 2,000,000,000 50% AsS ets $4,000,000,000 100% (Ratio of gold to loans, 100%,) With half the assets in gold, interest rates are usually normal. There is room for business to expand. Let us suppose that business does expand, and that the increase in the volume of trade with prices rising causes loans to mount higher. What then will be the proportion of assets in gold? As a first step, let us assume that loans have increased 25 per cent, or $500,000,000. Will the bank statement be as follows? 22 Business Cycles Expanded Credit Position. (Gold assumed stationary) Loans $2,500,000,000 55.6% Gold 2,000,000,000 44.4% Assets $4,500,000,0000 100% (Ratio of gold to loans, 80%) No. An assumption that gold will remain stationary while loans increase is not true to life. It would ignore the actual dynamics of business activity. In actual business experience, the gold reserves would have decreased while loans were ex- panding. The above table should be corrected to read as follows: Expanded Credit Position. (Gold reduced) Loans $2,500,000,000 58.1% Gold 1,800,000,000 41.9% Assets $4,300,000,000 100% (Ratio of gold to loans, 70.2%) International Influences The explanation of the loss in gold is found in the fact that trade is international. When trade expands and loans increase, some of the funds obtained by manufacturers will most certainly be used to buy imported goods. For instance, in the United States the Central Leather, American Woolen, United States Rubber and Manhattan Shirt companies respectively must im- port hides and wool from South America and Australia and rubber and silk from the Orient. Then, during prosperity, the imports of sugar from Cuba, coffee from Brazil and precious stones from South Africa increase. Gold must be sent to pay for these imports, or at least that part of them not balanced by shipments of steel, copper, cotton and other American products. But this loss of gold cannot continue indefinitely. That is. The Normal Cycle 23 the loss of gold must be stopped if the gold standard of payment is to be maintained. Of course, in an emergency, it is sometimes found necessary to suspend gold payment and ship an indefinite amount of gold out of the country. For instance, during the Napoleonic wars the British government shipped so much gold to. Austria to finance the armies fighting against Napoleon that the Bank of England discontinued paying its obligations in gold. In case of famine arising from domestic crop failure it is some- times necessary to make abnormal shipments of gold to foreign countries to procure food. These two circumstances — famine and military necessity — can force the governors of a central bank to depart from the ordinary rules of bank management. Increasing the Gold Reserves In discussing the normal cycle, however, we may assume the absence of famine and military necessity. Normally, it is de- sirable to maintain the gold standard, and to do this, after credit expansion has proceeded to the point where the gold reserves of the central bank have fallen to an uncomfortably low figure, the central bank normally does two things: 1. It restricts lending, and 2. Increases discount rates to 6, 7 or if necessary to 8 or 10 per cent. Either one or both of these policies will cause congestion in the security markets and precipitate deflation of prices. Gradu- ally loans will decrease. There will be less gold needed for re- mittances between countries to settle trade balances, as soon as trade slows down and commodity values fall. Gold will accumu- late in the central banks. These banks will be restored to a normal condition, in fact, their gold reserves become abnormally large during a period of trade depression. For instance, in the following table, where gold holdings are larger than the loans, the supply of loanable funds may be adjudged to be above normal. 24 Business Cycles Credit Deflated ; Loanable Funds Abundant Loans $1,800,000,000 45% Gold 2,200,000,000 55% Assets $4,000,000,000 100%, (Ratio of gold to loans, 122.2%) When the bank statement reaches this point, the banks "breathe easily," and there is a fall in interest rates which favors a revival of financial activity. Cause and Effect The business cycle, then, is the direct resultant of the flow of loanable funds. The motor which impels the cycle forward is the supply of bank credit. The supply of loanable funds is our "cycle gas." As funds are put into circulation, they swell wages and profits. The Business Index rises. The index of loanable funds corres- pondingly declines. When the pumping of new funds into com- mercial enterprise is at an end, wages, prices and profits come to a dead standstill. Then lenders withdraw their funds gradu- ally from the borrowers. Payrolls grow smaller. The aggre- gate income of the community declines. The curve representing the cycle falls below normal. But meanwhile there is an in- creasing accumulation of loanable funds. We find that the supply of funds is well above normal by the time the cycle touches the minimum of depression. WTien the supply of "cycle gas" is once again abundant, the normal trend of general busi- ness soon turns upward marking the beginning of a new cycle. This completes our statement of the ideal concept of the "normal cycle." The practical problem now is to find, in the actual world of finance, the statistical barometers which will enable us to state accurately whether the supply of loanable funds is abundant or exhausted, or in some intermediate posi- tion. Needless to say, no one statistical barometer tells the whole story. Not all financial areas register "low barometer" The Normal Cycle 25 or "high barometer" simultaneously. There are local differences in the United States, and very frequently the financial resources of Paris, Berlin, and London exhibit differing degrees of abund- ance or depletion. Then, we must always consider the flow of gold toward South America, Asia and other parts of the world. The idea of a world reservoir of loanable funds is a simple con- cept in the abstract, but in actual practice, a careful survey is necessary to grasp the situation as a whole. We find, however, that indexes of money conditions in New York, London and Paris usually satisfy our requirements for mechanical barometers. Conditions in the rest of the world are visualized in the financial barometers of these three cities to a large extent. To illustrate this point let us make a special study of the cycle culminating in the Panic of 1907. New York Financial Barometers What are the best financial barometers of conditions in Wall Street? Perhaps the average investor would care little about a mechanical index based on statistics if he could lunch at the Waldorf Astoria with a prominent New York banker and derive his information regarding the financial outlook during the course of the noonday conversation. In our opinion, how- ever, less could be gained from such a conversation than can be learned from an analysis of the reserves, loans and deposits of the banks in the New York Clearing House which are published every week. We not only have the statistical information which the bankers possess, but every day in the week we can ascertain the opinions of the bankers themselves regarding their own statements. If a banker thinks his balance sheet is growing worse he will increase his discount rate. If he has on hand an abundant surplus of loanable funds, a very low rate of interest, (published in the newspapers) will give us positive evidence of the fact. Thus, by following the changes in the items of the balance sheets of the banks every week and the interest rates quoted in the papers every day, we can know accurately what the banking situation is and what the bankers think about it. 26 Business Cycles Conditions 1904-08 Let us put this system to a practical test during the period from 1904 to 1908. We shall select two items from the New- York bank statement, namely, the percentage of loans^to de- Money Conditions in New York posits and the ratio of reserves to loans. These two items tell us the condition of the banks. Having plotted these statistics on a chart, let us add a line showing interest rates in New York. We have now a picture of money conditions in New York as The Normal Cycle 27 shown in the diagram on opposite page. The interpretation is that as there is a rise in the percentage of loans on deposits, and a fall in the ratio of reserves to loans, the banks elevate interest rates to check borrowing. Reversely, when reserves rise and the ratio of loans to deposits falls, interest rates are lowered, as in 1908. Barometers of European Financial Conditions Meanwhile, what is the situation in Europe? And what indexes shall we select from London and Paris? In the period 1904-08 the important indexes in London were the cash reserve of the Bank of England and interest rates in London. In Paris, the chief barometer was the condition of the Bank of France. Paris held more gold than London, hence the importance of the Bank of France as a source of assistance to London in time of need. But London held more American securities than Paris, hence the rate of interest in London decisively affected the prices of American securities. In charting European barometers, then, let us plot the ratio of reserves to note circulation of the Bank of France at the bottom of our chart, and immediately above it the official bank rate of the Bank of England. Now, we can add a graph of prices of American stocks and we are ready to judge the effect of European conditions upon the New York Stock Market during 1904-08. Our first impression from this diagram is that activities in Wall Street move very promptly in discounting conditions in Europe. For instance, when Paris and London reflected easy money in 1904, the stock market advanced enough during 1904 and 1905 to discount all of the prosperity which was to develop during 1906-07. Then in 1907 the stock market declined more than enough to measure the depression which developed during 1908. In the latter year, even before Paris was financially normal, Wall Street proceeded to anticipate the outlook for im- provement abroad. The resources of the Bank of France did not entirely recover until 1909, but by the time financial condi- tions were approaching normal in Europe, the New York Stock Market had recovered most of the loss suffered during the Panic of 1907. 28 Business Cy cle s Our conclusion, then, is that although conditions in Europe had a fundamental relation to speculation in Wall Street during 1904-08, the American investor had to be alert and foresee i wt I i