L. Pohle, Periodische Wirtschaftskrisen, especially sec. IT. with sub-

joined notes.

THE THEORY OF MODERN WELFARE 183

The true, or what may be called the normal,
crises, depressions, and exaltations in the business
world are not the result of accidents, such as the
failure of a crop. They come in the regular course
of business. The depression and the exaltation are
in a measure bound together. In the recent past,
since depression and exaltation have been normal
features of the situation, every strongly marked
period of exaltation (prosperity) has had its attend-
ant period of depression; although it does not
seem to follow in the nature of things that a wave
of depression necessarily has its attendant reaction
in the way of a period of business exaltation. In
the recent past—the last twenty years or so— it
has been by no means anomalous to have a period
of hard times, or even a fairly pronounced crisis,
without a wave of marked exaltation either pre-
ceding or following it in such close sequence as
conveniently to connect the two as action and re-
action. But it would be a matter of some perplex-
ity to a student of this class of phenomena to come
upon a wave of marked business exaltation (pros-
perity) that was not promptly followed by a crisis
or by a period of depression more or less pro-
nounced and prolonged. Indeed, as the organiza-
tion of business has approached more and more
nearly to the relatively consummate situation of
to-day, — say during the last twenty years of the
nineteenth century, — periods of exaltation have,

184 THE THEORY OF BUSINESS ENTERPRISE

on the whole, grown less pronounced and less fre-
quent, whereas periods of depression or “hard
times” have grown more frequent and prolonged,
if not more pronounced. It might even be a ten-
able generalization, though perhaps unnecessarily
broad, to say that for a couple of decades past the
normal condition of industrial business has been
a mild but chronic state of depression, and that
any marked departure from commonplace dull
times has attracted attention as a particular case
calling for a particular explanation. The causes
which have given rise to any one of the more
pronounced intervals of prosperity during the past
two decades are commonly not very difficult to
trace; but it would be a bootless quest to go out in
search of special causes to which to trace back each
of the several periods of dull times that account
for the greater portion of the past quarter of a
century. Under the more fully developed business
system as it has stood during the close of the cen-
tury dull times are, in a way, the course of nature ;
whereas brisk times are an exceptional invention
of man or a rare bounty of Providence.

What current economic theory has to say on the
common welfare is more frequently found under
the caption of crisis and depression than in any
other one connection. And the theory of crisis
and depression has, as is well known, been one of
the less happy passages in the economists’ reper:

THE THEORY OF MODERN WELFARE 185

tory of doctrines. It has been customary to ap-
proach the problem from the side of the industrial
phenomena involved—the mechanical facts of
production and consumption; rather than from
the side of business enterprise — the phenomena of
price, earnings, and capitalization. This untoward
accident of a false start is probably accountable for
the fact that no tenable theory of these phenomena
has yet been offered. The solutions attempted
have commonly proceeded by an analysis of indus-
trial life apart from business enterprise; that is to
say, they have sought to explain the occurrence of
crises under that old-fashioned “natural economy ”
or. “money economy” under which crises did not
normally occur.’

Taking as a point of departure the patent fact
that crises, depressions, and brisk times are in their
first incidence phenomena of business, of prices
and capitalization, an explanation of their appear-
ance and disappearance, and of their bearing upon
the common welfare, may be sought by harking
back to those business principles that underlie

1 This is well exemplified in Tugan-Baranowsky (Handelskrisen),
who declares at the outset (p. 17) that money and price are negligible
factors for the purpose in hand, He thereby commits himself to the
position that these crises are phenomena of the material processes
of economic life (production and consumption), not of business traffic.
Hence the ultimate failure of this acute observer and theoretician to
reach a tenable solution of the question. Substantially the same is
true of Marx, whom Tugan follows, though with large reservations,
(Cf. Marx, Kapital, vol. 11. ch. XV.)

186 THE THEORY OF BUSINESS ENTERPRISE

modern capitalistic enterprise. An analysis of the
current, common-sense business views of price and
investment should indicate the genesis and manner
of growth of these mass movements of the business
community, as well as the character of those cir-
cumstances which may further or inhibit such
movements. Business depression and exaltation
are, at least in their first imcidence, of the nature
of psychological fact, just as price movements are
a psychological phenomenon.

The everyday circumstances which condition
the modern business management of industry are
sufficiently well known, and they have already
been reviewed in some detail in earlier chapters ;
but they may perhaps advantageously be outlined
again in so far as they bear immediately on the
question in hand.

(1) Industry is carried on by means of invest-
ment, which is made with a. view to pecuniary
gain (the earnings). The business man’s endeav-
ors in managing the affairs of the concern in which
investment has been made look to the same end.
The gains are kept account of as a percentage on
the investment, and both they and the industrial
plant or process through the management of which
they are procured are counted in terms of money,
and, indeed, in no other terms. The plant or
process (or the investment, whatever form it takes)
18 capitalized on the basis of the gains which accrue

THE THEORY OF MODERN WELFARE 187

from it, and this capitalization proceeds on the ground
afforded by the current rate of interest, weighted
by consideration of any prospective change in the
earning-capacity of the concern. The management
of the concern is effected by a more or less intri-
cate and multifarious sequence of bargains. The
decisive consideration at every point in this traffic
of investment and administration is the considera-
tion of price in one relation or another.

(2) The industry to which the business men in
this way resort as the ways and means of gain is
of the nature of a mechanical process, or it is
some employment (as commerce or banking) that
is closely bound up with the mechanical industries.
Broadly, it is such industry as lies under the
dominion of the machine, in that it is involved in
that comprehensive quasi-mechanical process of
modern industrial life that has been discussed in an
earlier chapter. This implication of each industry
in a comprehensive system, or this articulation with
other branches of industry, is of such a nature
as to place each industrial concern in dependence
on one or more other branches of industry, from
which it draws its materials, appliances, etc., and
to which it disposes of its output; and these rela-
tions of dependence and articulation form an end-
less sequence. That is to say, the interindustrial
relations into which any branch of industry neces-
sarily enters do not run to a final term in any

188 THE THEORY OF BUSINESS ENTERPRISE

direction; within the process of industry at large
there is no member that stands in the relation of
an initial term to any sequence of processes. The
ramification of industrial dependence is without
limits. The method of these relations of one con-
cern to another, or of one branch of industry to
another, is that of bargaining, contracts of pur-
chase and sale. It is a pecuniary relation, in the
last resort a price relation, and the balance of this
system of interstitial relations is a price balance.
(3) These interstitial pecuniary relations, be-
tween the several concerns or branches of industry
that make up the comprehensive industrial system
at large, involve credit relations of greater or less
duration. The bargaining, by means of which in-
dustry is managed and the interstitial relations
adjusted, takes the form of contracts for future
performance. All industrial concerns of appre-
ciable size are constantly involved in such con-
tracts, which are, on an average, of considerable
magnitude and duration, and commonly extend
in several directions. These contracts may be of
the nature of loans, advances, outstanding ac-
counts, engagements for future delivery or future
acceptance, but in the nature of the case they
involve credit obligations. Credit, whether under
that name or under the name of orders, contracts,
accounts, and the like, is inseparable from the
management of modern industry in all that con-

THE THEORY OF MODERN WELFARE 189

cerns the working relations between businesses that
are not under one ownership, or between which
the relations resting on separate ownership have
not been placed in abeyance by some such expe-
dient as lease, pool, syndicate, trust agreement, and
the like. Credit relations of one kind and another
are also found expedient and profitable at many
points where their employment is not precisely
unavoidable. These extended credit relations are
requisite to the most expeditious and profitable
conduct of business, and so to the highest degree
of success of the business. Under the régime of
the machine industry and modern business methods
it is probably fair to say that the use of credit,
apart from loan capital and leases, unavoidably
goes to the extent required to cover all goods in
process of elaboration, from the raw material
to the finished goods, in so far as the goods change
hands (in point of ownership) during the process.

(4) The conduct of industry by competing busi-
ness concerns involves an extensive use of loan
credit, as spoken of in Chapter V. above.

The four conditions recited are characteristic
features of that recent past during which brisk
times, crises, and depressions followed one another
with some regularity as incidents of the normal
course of business.' Certain qualifications of this

1 The ‘cycle’? of exaltation, crisis, and depression has frequently
been described. Perhaps as effective a description and analysis as
any is that of Tugan-Baranowsky, Handelskrisen, chap. VIII.

190 THE THEORY OF BUSINESS ENTERPRISE

characterization are necessary to fit the immediate
present. These will be indicated presently.

In brisk times the use of credit is large; it may
be as a cause or an effect of the acceleration of
business; most commonly it seems to be both a
cause and an effect. No appreciable busmess
acceleration takes place without an extension of
credit, at least in the form of contracts of purchase
and sale for future performance, if not also in the
form of loans. In times of protracted depression
the use of credit seems on the whole to be some-
what restricted, at least such is the current appre-
hension of the case among busmess men. Still, it
cannot confidently be said that seasons of pro-
tracted depression are due solely to an absence of
credit relations or to an unwillingness to enter into
credit relations. A comparison of the course of
interest rates, e.g., does not warrant the generaliza-
tion that the readiness with which loans can be
negotiated need be appreciably different in brisk
and in dull times." The readiness with which con-
tracts of purchase and sale are negotiated is appre-
ciably greater in brisk times than in times of
depression ; that, indeed, is the obvious difference
between the two.

Of the three phases of business activity, depres-
sion, exaltation, and crisis, the last named has

Cf., however, Cassel, ‘‘Om Kriser och D&aliga Tider,’’ Ekonomisk
Tidskrift, vol. VI, No. 2, pp. 59-78.

THE THEORY OF MODERN WELFARE 191

claimed the larger and livelier attention from
students, as it is also the more picturesque phenom-
enon. An industrial crisis is a period of liquida-
tion, cancelment of credits, high discount rates,
falling prices and “ forced sales,” and shrinkage of
values. It has as a sequel, both severe and lasting,
a shrinkage of capitalization throughout the field
affected by it. It leaves the business men col-
lectively poorer, in terms of money value; but the
property which they hold between them may not
be appreciably smaller in point of physical magni-
tude or of mechanical efficiency than it was before
the liquidation set in. It commonly also involves
an appreciable curtailment of industry, more severe
than lastmg; but the effects which a crisis has in
industry proper are commonly not commensurate
with its consequences in business or with the
importance attached to a crisis by the business
community. It does not commonly involve an
appreciable destruction of property or a large waste
of the material articles of wealth. It leaves the
community at large poorer in point of market
values, but not necessarily in terms of the material
means of life. The shrinkage incident to a crisis
is chiefly a pecuniary, not a material, shrinkage ; it
takes place primarily in the intangible items of
wealth, secondarily in the price rating of the tang?
ble items. Apart from such rerating of wealth, the
most substantial immediate effect of a crisis is an

192 THE THEORY OF BUSINESS ENTERPRISE

extensive redistribution of the ownership of the
industrial equipment, as noted in speaking of the
use of credit.

The play of business exigencies which lead to
such a period of liquidation seems to run somewhat
as follows: Many firms have large bills payable
falling due at near dates, at the same time that
they hold bills receivable also in large amounts.
To meet the demand of their creditors they call
upon their debtors, who may in their turn have
bills receivable or may hold loans on collateral.
The initial move in the sequence of liquidation
may be the calling in of a call loan, or a call for
additional collateral on a call loan. At some
point, earlier or later, in the sequence of liabilities
the demand falls upon the holder of a loan on
collateral which is, in the apprehension of his
creditor, insufficient to secure ready liquidation,
either by a shifting of the loan or by a sale of the
collateral. The collateral is commonly a block of
securities representing capitalized wealth, and the
apprehension of the creditor may be formulated as
a doubt of the conservative character of the
effective capitalization on which it rests. In other
words, there is an apprehension that the property
represented by the collateral is overcapitalized, as
tested by the current quotations, or by the appre-
hended future quotations, of the securities in
question. The market capitalization of the col-

THE THEORY OF MODERN WELFARE 193

lateral has taken place on the basis of high prices
and brisk trade which prevail in such a period of
business exaltation as always precedes an acute
crisis. When such a call comes upon a given
debtor, the call is passed along to the debtors
farther along in the sequence of liabilities, and the
sequence of liquidations thereby gets under way,
with the effect, notorious through unbroken expe-
rience, that the collateral all along the line declines
in the market. The crisis is thereby in action,
and the further consequences follow as a well-
known matter of course. All this is familiar
matter, known to business men and students by
common notoriety.

The immediate occasion of such a crisis, then,
is that there arises a practical discrepancy between
the earlier effective capitalization on which the
collateral has been accepted by the creditors, and
the subsequent effective capitalization of the same
collateral shown by quotations and sales of the
securities on the market. But since the earlier
capitalization commonly, in the normal case,
comes out of a period of business prosperity, the
point of inquiry is as to the ground and method
of this effective capitalization of collateral during
the period of prosperity that goes before a crisis,
and this, in turn, involves the question of the
nature and causes of a period of prosperity.

The manner in which the capitalization of col-

194 THE THEORY OF BUSINESS ENTERPRISE

lateral, and thereby the discrepancy between the
putative and actual earning-capacity of capital, is
increased by loan credit during an era of prosperity
has been indicated in some detail in Chapter V.
above. But it may serve to enforce the view there
taken, if it can be shown on similar lines that a
period of prosperity will bring on a like discrepancy
between putative and actual earning-capacity, and
therefore between putative and eventual capitali-
zation of collateral, even independently of the
expansion effected by loan credit.

A period of prosperity is no more a matter of
course than a crisis. It has its begmning in some
specific combination of circumstances. It takes its
rise from some traceable favorable disturbance of
the course of business. In such a period the
potent fact which serves as incentive to the accel-
eration of business is a rise of prices. This rise of
prices presently becomes general as _ prosperity
progresses and becomes an habitual fact, but it
takes its start from some specific initial disturbance
of prices. That is to say, prices rise first in some
one industry or line of industries.’

1 As, e.g., the era of prosperity 1897-1902 took its start from the
demand for supplies caused by the Spanish-American War, though
other favorable circumstances acted to give it volume. Mr. Carver,
possibly following suggestions given by Spiethoff’s discussion, has
suggested that the lines of business in which the favorable initial dis-
turbance arises are necessarily those engaged in the production of
‘‘producer’s goods”’ ; the reason for this being that, in the nature of
the case, ‘‘ the value of producer’s goods tends to fluctuate more vio

THE THEORY OF MODERN WELFARE 195

By new investments, as well as by extending the
operations of the plants already employed, busi-
ness men forthwith endeavor to take advantage of
such a rise. The endeavor to market an increased
supply of the things for which there is an en-
larged demand, brings on an increased demand
and an advance of prices in those lines of indus-
try from which the concerns that had the initial
advantage draw their supplies. In part by actual
increase of demand and in part through a lively
anticipation of an advanced demand, aggressive
business enterprise extends its ventures and pushes
up prices in remoter lines of industry. This trans-
mission of the favorable disturbance of business
(substantially a psychological phenomenon) follows
very promptly under modern conditions, so that
any differential advantage that accrues at the out-
set to the particular line of industry upon which
the initial disturbance falls is presently lost or
greatly lessened. In the meantime extensive
contracts for future performance are entered into
in all directions, and this extensive implication of

lently than the value of consumer’s goods,’’ inasmuch as the value of
producer’s goods varies somewhat as the magnitude of the margin of
profits, while that of the consumer’s goods varies somewhat as the
magnitude of the entire demand on which this margin of profits rests
asanincrement. (The value of producer’s goods = f (A), that of con-
sumer’s goods=f (demand +A).) From the like line of argument
it should follow that the initial break in time of crisis must come in
some line of business occupied with producer’s goods. Cf. Quarterly
Journal of Economics, May 19038, pp. 497-500. See also foot-note on
p. 181 above,

196 THE THEORY OF BUSINESS ENTERPRISE

the various lines of industry serves, of itself, to
maintain the prosperity for the time being. If
the original favorable disturbance of demand and
prices, to which the prosperity owes its rise, falls
off to the earlier level of demand, the era of pros-
perity has thereby a term set to its run; although
the date of its termination is always at some dis-
tance in the future, beyond the time when the
original demand has ceased to act. The reason
for this retardation, whereby the close of an era
of prosperity is always delayed, other things equal,
beyond the lapse of the cause from which it has
arisen, 1s (1) the habit of buoyancy, or speculative
recklessness, which grows up in any business com-
munity under such circumstances, (2) the con-
tinued life of a considerable body of contracts for
future performance, which acts to keep up the
demand for such things as are required in order
to fill these contracts and thereby keeps up prices
in so far. In general it may be said that after
the failure of the favorable price disturbance to
which it is due, an era of prosperity will continue
for that (indefinite) further period during which
the fringe of outstanding contracts continues to
dominate the business situation. Some further,
new contracts will always continue to be made
during this period, and some unfilled contracts
will always be left standing over when the liqui-
dation sets in; but, broadly speaking, the wind-up

THE THEORY OF MODERN WELFARE 197

comes, not when this body of outstanding contracts
have run out or been filled, but when the business
of filling them and of filling the orders to which
they give rise no longer occupies the attention of
the business community in greater measure than
the rest of current business.

The run of business exigencies on which an era
of prosperity goes forward may be sketched in its
general features somewhat as follows: Increased
demand and enhanced prices, with the large con-
tracts which follow from such a state of the
market, increase the prospective earnings of the
several concerns engaged. These prospective earn-
ings may eventually be realized in full measure,
or they may turn out to have been putative earn-
ings only; that is largely a question of how far
in the future the liquidation lies. The business
effect of increased prospective earnings, however,
is much the same whether the event proves the
expectation of increased earnings to have been
well grounded or not. The expectation in either
case leads the business men to bid high for equip-
ment and supplies. Thereby the effective (mar-
ket) capitalization is increased to answer to the
increased prospective earnings. This recapitali-
zation of industrial property, on the basis of
heightened expectation, increases the value of this
property as collateral. The inflated property be-
comes, in effect, collateral even without a formal

198 THE THEORY OF BUSINESS ENTERPRISE

extension of credit in the way of loans; because,
in effect, the contracts entered into are a credit
extension, and because the property of the con-
tracting parties is lable to be drawn into liquida-
tion in case of non-fulfilment of the contracts.
But during the free swing of that buoyant enter-
prise that characterizes an era of prosperity con-
tracts are entered into with a somewhat easy
scrutiny of the property values available to secure
a contract. So that as regards this point not only
is the capitalization of the industrial property in-
flated on the basis of expectation, but in the mak-
ing of contracts the margin of security is less
closely looked after than it is in the making of
loans on collateral. There results a discrepancy
between the effective capitalization durmg pros-
perity and the capitalization as it stood before
the prosperity set in, and the heightened capitali-
zation becomes the basis of an extensive ramifi-
cation of credit in the way of contracts (orders) ;
at the same time the volume of loan credit, in
set form, is also greatly increased during an era
of prosperity.’

An era of prosperity is an era of rising prices.
When prices cease to rise prosperity is on the wane,
although it may not promptly terminate at that
juncture. This follows from the fact that the

1Cf. Sombart, Kapitalismus, vol. Il. ch. I., on the motive forces
at work in advancing business enterprise,

THE THEORY OF MODERN WELFARE 199

putative increase of earnings on which prosperity
rests is in substance an apprehended differential
gain in increased selling price of the output over
the expenses of production of the output. Only
so long as the selling price of the output realizes
such a differential gain over the expenses of pro-
duction, is the putative increased rate of earnings
realized ; and so soon as such a differential advan-
tage ceases, the era of prosperity enters on its clos-
ing phase.

Such a differential advantage arises mainly from
two causes: (1) The lines of industry which are
remote, industrially speaking, from the point of
initial disturbance, — from which, that is to say,
the lines of industry first and chiefly affected by the
rise draw supplies of one kind or another, — these
remote lines of industry are less promptly and less
acutely affected by the favorable disturbance of the
price level; this retardation of the disturbance
affords the industries nearer the seat of disturbance a
differential advantage, which grows less the farther
removed the given enterprise is from the point of
initial disturbance. (2) The chief and most secure
differential advantage in the case is that due to

1 The ‘initial disturbance ’’ here spoken of may of course be of a
progressive or recurring character, and so may keep the differential
advantage going in a progressive manner ; as, ¢.g., in the case of a pro-
gressive demand for supplies due to a protracted war or to a period of
continued preparation for war, such as has occurred in America during
the last few years,

200 THE THEORY OF BUSINESS ENTERPRISE

the relatively slow advance in the cost of labor
during an era of prosperity. Wages ordinarily are
not advanced at all for a considerable period after
such an era of prosperity has set in; and so long
as the eventual advance of wages does not overtake
the advance in prices (which in the common run of
cases it never does in full measure), so long, of
course, a differential gain in the selling price ac-
crues, other things equal, to virtually all business
enterprises engaged in the industries affected by
the prosperity.

There are, further, certain (outlying) lines of
industry, as, e.g., farming, which may not be drawn
into the movement in any appreciable degree,and the
price of supplies drawn from these outlying indus-
tries need not rise; particularly they need not
advance in a degree proportionate to the advance
in the prices of the goods ito which they enter as
an element of their expenses of production. To an
uncertain but commonly appreciable extent there
is also a progressive cheapening of the processes
of production during such an era, and this cheap-
ening, particularly in so far as it affects the pro-
duction of the goods contracted for, as contrasted
with the appliances of production, serves also to
maintain the differential advantage between the
contracted sale price and the expenses of produc-
tion of the goods contracted for.

In the ordinary course, however, the necessary

THE THEORY OF MODERN WELFARE 201

expenses of production presently overtake or nearly
overtake the prospective selling price of the out-
put. The differential advantage, on which business
prosperity rests, then fails; the rate of earnings
falls off; the enhanced capitalization based on en-
hanced putative earnings proves greater than the
earnings realized or in prospect on the basis of an
enhanced scale of expenses of production; the col-
lateral consequently shrinks to a point where it
will not support the credit extension resting on it
in the way of outstanding contracts and loans; and
liquidation ensues, after the manner frequently set
forth by those who have written on these subjects.'

At some point in the system of investment and
business extension will be found some branches of
industry which have gradually lost what differen-

1 There is a point or two of further detail in what may be called the
method of prosperity and crisis, which are best discussed in connec-
tion with the phenomena of depression. These will, therefore, be
taken up presently. The above characterization of an era of prosper-
ity and the manner of its exhausting itself will serve as a description
of the course which such an era takes under the régime of the more
highly developed business methods of the high tide of the nineteenth
century. For the earlier, less fully developed, business situation of
the early nineteenth century the corresponding course of events runs
somewhat different, owing, chiefly at least, (1) to a slower rate of trans-
mission of any price disturbance, and (2) to the greater range and
value of *‘outlying’’ industries which are very tardily if at all drawn
into the exuberant movement of prosperity. In this connection it is
worth noting that during this earlier period of the ninteenth century
the production of specifically productive goods had not been carried
to the point afterward attained, either in the differentiation and
specialization of industries occupied with this class of goods or in the
relative volume of this class of industries.

202 THE THEORY OF BUSINESS ENTERPRISE

tial advantage they started out with when they
entered on the era of prosperity; and if these
are involved in large contracts and undertakings
which are carried over into the phase of the
movement at which this particular branch of in-
dustry has ceased to have a differential advantage
in the price of its output over the cost of its sup-
plies of material or labor, then what may have
been a conservative capitalization of their hold-
ings at an early phase, while their earning-ca-
pacity rested on a large differential advantage,
will become an excessive capitalization after their
earning-capacity has declined through loss of their
differential advantage. Some branch or branches
and some firms or class of firms necessarily fall
into this position im the course of a period of
phenomenally brisk times. A business concern so
placed necessarily becomes a debtor, and its liabili-
ties necessarily become, in some degree, bad debts.
It is forced by circumstances to deliver its output
at prices which preclude its obtaining such a
margm as its extension of business presupposed.
That is to say, its capitalization becomes exces-
sive through shrinkage of its earning-capacity
(as counted in terms of price). A concern of this
class which is a debtor is precluded from meeting
its obligations out of its current earnings; and if,
as commonly happens in an appreciable proportion
of cases, its obligations have already been aug-

THE THEORY OF MODERN WELFARE 203

mented to the extent which its recent earning-
capacity would warrant, then the concern is in-
solvent for the time being. If the claims against
it are pressed, it has no recourse but liquidation
through forced sales or bankruptcy. Either ex-
pedient, if the case is one of considerable magni-
tude, is disastrous to the balanced sequence of
eredit relations in which the busmess community
is involved. The system of credit relations pre-
vailing at such a time has grown up on the basis
of an earning-capacity transiently enhanced by a
wave of differential price advantage; and when
this wave has passed, even if it leaves prices
higher all around, the differential advantage of
at least most concerns is past. The differential
price advantage has come to the several branches
or firms in succession, and has, in the typical case,
successively left each with an excessive capitaliza-
tion, and has left many with a body of liabilities
out of proportion to their subsequent earning-
capacity. This situation may, evidently, come
about in this manner, even without lowering the
aggregate (pecuniary) earning-capacity of the busi-
ness community to the level at which it stood
before the wave of prosperity set in.’

1 The several phases of this sequence of exaltation and depression,
for any given business concern, may be stated as follows : —

Let ea = earnings ; pr = sale price of output; exp = expenses of
production of output; mar = margin of gain on output = pr— exp;
cap = initial effective capitalization ; yp = year’s purchase at (current

204 THE THEORY OF BUSINESS ENTERPRISE

But when such a situation has come, all that is
required to bring on the general catastrophe 1s
that some considerable creditor find out that the
present earning-capacity of his debtor will prob-
ably not warrant the capitalization on which his
collateral is appraised. In self-defence he must
decline the extension of a loan, and forced liquida-
tion must follow. Such a liquidation involves

rates = int) = —, disregarding risk ; cr = normal credit extension on
int

=P. (
given cap = ==) = as ale
Then at be initial phase,
ea = (mar = pr — exp)outp,
cap = ea x yp =,
int

At the subsequent phase, of exaltation,
ea! = ea + Aea = mar! x outp
= [(pr’= pr + Apr) — exp] outp
= (mar + Amar) outp > ea,
ea! _ 6a S —
intice fmt
cap! cap ah Acap

ex! = —— = —____—
n n pace

At the concluding phase, of depression,

cap/ = — > cap,

ea!!— ea! — Aea! = mar’! x outp
=[pr’— Coa = exp + Aexp) ] outp < ea!

ne = en
int in Ps
cap!! nS A cap!
enllie = 2 cr’.

For simplicity of statement, in all this no account is taken of the
element of risk, nor of the fluctuations of discount rates or the variations
of volume of output. If these be included in the calculation as vari-
ables, the result is much the same. They are functions of the variables
already included, and their inclusion would, on the whole, accentuate
the oscillations shown by the computation as it stands.

THE THEORY OF MODERN WELFARE 205

cutting under the ruling prices of products, which
lessens the profits of competing firms and throws
them into the class of insolvents, and so extends
the readjustment of capitalization.

The point of departure for the ensuing sequence
of liquidation is not infrequently the failure of
some banking house, but when this is the case it
is pretty sure to be a bank whose funds have been
“tied up” in “unwise” loans to industrial enter-
prises of the class spoken of above.!

The abruptness of the recapitalization and of the
redistribution of ownership involved in a period of
liquidation may be greatly mitigated, and the
incidence of the shrinkage of values may be more
equably distributed, by a judicious leniency on the
part of the creditors or by a well-advised and dis-
creetly weighted extension of credit by the govern-
ment to certain sections of the business community.
Such measures of alleviation were had, with happy
effect, in the case of a recent stringency which is
sometimes spoken of as an averted crisis. But
where the situation answers the specifications

1A crisis may take its rise from credit extension in other than
properly industrial business, Such, ¢.g., was in great measure the
American crisis in 1837, when the most obvious and disastrous infla-
tion was in speculative land values and the credits based on them.
But it is no stretch of the concept to say that in that case the situation
out of which the crisis arose was an overcapitalization of the land
yalues in question. Capitalized land is, of course, ‘‘ capital’ for busi-
ness purposes as truly as any other body of values that are capitalized
and drawn into the money market.

206 THE THEORY OF BUSINESS ENTERPRISE

recited above, in respect of a large and widely
prevalent discrepancy between earning-capacity
and capitalization, a drastic readjustment of values
is apparently unavoidable.

The point has already been adverted to once or
twice that the most substantial immediate outcome
of such a liquidation as is involved in a crisis is a
redistribution of the ownership of the property
concerned in the liquidation, whereby creditors and
similar claimants gain at the expense of the sol-
vent debtors. Such being the case, it would logi-
cally follow that the large creditors should see and
follow up their advantage by concertedly pushing
the body of debtors to an abrupt liquidation, and so
realizing as large a gain as possible with the least
practicable delay, whenever the situation offers.

Such may be the logic of the circumstances, but
such is not the course practically taken by the
large creditors under the circumstances. For this
there is more than one reason. It is not, appar-
ently, that human kindness overrules the creditors’
impulse to gain at the expense of the debtors. The
ever recurring object-lessons afforded by operations
in the stock and money market enforce the belief
that when one business man gets the advantage of
another he will commonly use the advantage with-
out humanitarian reserve, if only the advantage is
offered him in terms which he can comprehend.
But short-sightedness and lack of insight beyond

THE THEORY OF MODERN WELFARE 207

the conventional routine seem to be fairly univer-
sal traits of the class of men who engage in the
larger business activities. So that, while it would
be to the unequivocal advantage of the large cred-
itor, in point of material gain, to draw in his
debtor’s property at such a reduced valuation as
comes in a period of abrupt liquidation, yet he does
not ordinarily see the matter in that light; because
the liquidation involves a shrinkage of the money
value of the property concerned, and the business
man, creditor or debtor, is not in the habit of
looking beyond the money rating of the property
in question or beyond the most immediate future.
The conventional base line of business traffic, of
course, is the money value, and a recognition of
the patent fact that this base line wavers incon-
tinently, and that it may on occasion shift very
abruptly, apparently exceeds the business man’s
practical powers of comprehension. Money value
is his habitual bench-mark, and he holds to the
conviction that this bench-mark is stable, in spite
of the facts.’

1 Tt is, in great part, through or by force of fluctuations of this base
line of money values that large accumulations of wealth are made.
One might almost say that this is the ‘‘normal’’ method by which
savings are made and capitalized in later modern times. Fluctuations in
the stock market, of course, are of this character, as are commonly also
large variations of the course of prices outside the stock market, as well
as fluctuations of the money market. The great gains of successful
promoters of corporations and the like come in this manner usually.
They are due to enlargement of the money value of a given block of
industrial equipment independently of any change in the physical

208 THE THEORY OF BUSINESS ENTERPRISE

It is true, cases occur, from time to time, of
transactions of some appreciable magnitude in
which some degree of recognition of this fact is
met with. Some large business man may yet rise
to the requisite level of intelligence, and may com-
prehend and unreservedly act upon the fact that
the money base line of business traffic at large is
thoroughly unstable and may readily be manipu-
lated, and it will be worth gomg out of one’s way
to see the phenomenal gains and the picturesque
accompaniments of such a man’s work. Paren-
thetically it may be remarked that if such a degree
of insight should become the common property of
the business community, business traffic as now
carried on might conceivably collapse through loss
of its base line. What is yet lacking in order to
such a consummation is perhaps nothing more
serious than that business capital be reduced to a
somewhat more thorough state of intangibility
than it has yet attained, and that does not seem a
remote contingency.’

character of the equipment. Which comes near saying that the large
fortunes originate in such changes of the base line, —from which it
follows that the larger accretions to the volume of capital are of this
origin. The large profits are made in the form of capital, which is
acquired by virtue of a price variation. See foot-note, pp. 168-170.

1 A substantial move in this direction would be that advocated by
Mr. F. S. Stetson before the New York Bar Association, and reiterated
before the United States Industrial Commission : ‘‘ To permit the for-
mation of a distinct class of business stock corporations whose capital
stock may be issued as representing proportional parts of the whole
capital without any nominal or money value.” The market value of

THE THEORY OF MODERN WELFARE 209

There is, however, another and more constrain-
ing circumstance which hinders the large creditors
from wilfully pushing the debtors to a reckoning
when things are ripe for liquidation. As was
indicated above, the sequence of credit relations in
an era of prosperity is endlessly ramified through
the business community ; whereby it happens that
very few creditors are not also debtors, or stand in
such relation to debtors as would involve them in
some loss, even if this loss should not be commen-
surate with their eventual gain at the cost of
other debtors. This circumstance by itself has
a strong deterrent effect, and when taken in
connection with what was said above of the
habitual inability of the men in business to ap-
preciate the instability of money values, it is
probably sufficient to explain the apparently short-
sighted conduct of those large creditors to seek to
mitigate the severity of liquidation when the liqui-
dation has come due.

The account here offered of the “method” of
crises and eras of prosperity does not differ greatly
from accounts usually met with, except in explain-
ing these phenomena as primarily phenomena of
business rather than of industry. The disturbances
of the mechanical processes of industry, which are

such shares would be the only value assigned them, and little of a base
line in the way of a legally imputed value would remain. The de jure
value would no longer hinder a free recognition of the facts. — Report
of the Industrial Commission, vol. I. p. 976.

210 THE THEORY OF BUSINESS ENTERPRISE

a conspicuous feature of any period of crisis, follow
from the disturbance set up in the pecuniary traffic
instead of leading up to the latter. While industry
and business stand in a relation of mutual cause
and effect, in this as in other cases, the initiative
in such a movement belongs with the business
traffic rather than with the industrial processes.
Industry is controlled by business exigencies and
is carried on for business ends. The effects of a
wide disturbance in business, therefore, reach the
industrial processes pretty directly, and the conse-
quences, in the way of an expansion or curtail-
ment of industrial activity and an enlarged or
shortened output of product, are, of course, both
immediate and important. Asa primary effect, on
the industrial side, of an era of prosperity, the com-
munity gains greatly in aggregate material wealth.
The gain in material wealth, of course, is not equa-
bly distributed ; most of it goes to the larger busi-
ness men, eventually in great part to those who
come out of the subsequent liquidation on the credit
side. To some extent this aggregate material gain
is offset by the unavoidable waste incident to the
stagnation that attends upon an era of prosperity.
It is further offset by the fact that good times
carry with them an exceptionally wasteful expen-
diture in current consumption. Also, the usual
and more effectual impetus to an era of prosperity,
when it is not an inflation of the currency, is some

THE THEORY OF MODERN WELFARE 2\]1

form of wasteful expenditure, as, eg.,a sustained
war demand or the demand due to the increase of
armaments, naval and military, or again, such an
interference with the course of business as is
wrought by a differentially protective tariff. The
later history of America and Germany illustrates
both these methods of procuring an era of pros-
perity. These methods, it will be noticed, are, in
their primary incidence, of the nature of a waste of
industrial output or energy; but the prosperity
achieved is, none the less, to be recognized as a
beneficial outcome in point of heightened industrial
activity as well as in point of increased comfort
for the industrial classes.

To the workmen engaged in industry, particu-
larly, substantial benefits accrue from an era of pros-
perity. These benefits come, not in the way of larger
returns for a given amount of work, but more work,
fuller employment, at about the earlier rate of pay.
To the workmen it often means a very substantial
gain if they can get a fuller livelihood by working
harder or longer, and an era of prosperity gives them
a chance of this kind. Gradually, however, as pros-
perity—that is to say, the advancing price level—
rises and spreads, the increased cost of living
neutralizes the gain due to fuller employment, and
after the era of prosperity has been under way for
some time the gain in the amount of work obtain-
able is likely to be fairly offset by the increased

212 THE THEORY OF BUSINESS ENTERPRISE

cost of living. As noted above, much of the busi-
ness advantage gained in an era of prosperity is due
to the fact that wages advance more tardily than
the prices of goods. An era of prosperity does not
commonly bring an increase of wages until the era
is about to close. The advance of wages in such a
case is not only a symptom indicating that the
season of prosperity is passing, but it is a business
factor which must by its own proper effect close
the season of prosperity as soon as the advance
in wages becomes somewhat general. Increasing
wages cut away the securest ground of that differ-
ential price advantage on which an era of prosperity
runs.

Periods of crisis or of prosperity are, after all,
relatively simple phenomena with strongly marked
features, and a passable explanation of them is
correspondingly easy. They have also the advan-
tage of having received much attention at the hands
of the students of economic history. On the other
hand, protracted depression, not traceable to wide-
spread hardship or calamity arising from circum-
stances outside the range of business transactions,
is a relatively new and untried subject for economic
theory. Newer, more obscure, with less pronounced
features and less definite limits than movements of
speculative advance or speculative crises, this phe-
nomenon has to a less extent engaged the steady

THE THEORY OF MODERN WELFARE 213

attention of students. An inquiry into the life
history and the causes and effects of depression,
from the point of view of a theory of business, may
therefore scarcely be expected to yield concise or
secure conclusions.

Since industry waits upon business, it is a matter
of course that industrial depression is primarily a
depression in business. It is in business that de-
pression is felt, since it is on the business side of
economic activity that the seat of economic sensi-
bility may be said to lie; it is also in business (pe-
cuniary) terms that the depression is measured
whenever a measure or estimate of the matter is
attempted. In so far as there is an attendant
derangement of the mechanical processes and of the
mechanical articulation of processes in industry, the
derangement follows from the pecuniary exigencies
of business. Depression and industrial stagnation
follow only in case the pecuniary exigencies of the
situation are of such a character as to affect the
traffic of the business community in an inhibitory
way. But business is the quest of profits, and an
inhibition of this quest must touch the seat of its
vital motives. Industrial depression means that
the business men engaged do not see their way to
derive a satisfactory gain from letting the industrial
process go forward on the lines and in the volume for
which the material equipment of industry is de-
signed. It is not worth their while, and it might

214 THE THEORY OF BUSINESS ENTERPRISE

even work them pecuniary harm. Commonly their
apprehension of the discrepancy which forbids an
aggressive pursuit of industrial business is expressed
by the phrase “ overproduction.” An alternative
phrase, intended to cover the same concept, but less
frequently employed, is “ underconsumption.” *
The controversial question as to the tenability
of any given “overproduction” doctrine may, for
the present purpose, be left on one side; it lies out-
side the theory of business and it has no merits or
demerits for the purposes of a theory of business.
The point of interest here is rather the ground of
its acceptation among business men and the meaning
which this notion has for them; that is to say, it is
chiefly of interest here to inquire into the habits of
thought which give cogency and effect to the
dogma of “ overproduction” as practically held by
the body of business men,— what it practically
means, why the dogma is held, and what is its
effect on the course of business enterprise.
“Overproduction,” or “underconsumption,” as
it is met with in the views of business men, is
neither a vacant dogma nor a shifty apology where-
with to cover their own delinquencies, but a very
concretely real state of affairs. It is a state of
affairs that prevails when business is persistently

1 Cf. Hobson, Problem of the Unemployed, ch. V.; Vialles, La con-

sommation et les crises economiques, especially ‘‘ Introduction’? and
che itl.

THE THEORY OF MODERN WELFARE 215

dull; and the concept covered by the term com-
prises the sufficient cause of the dulness, in the
apprehension of the business community, even
though they may not always speak of the difficulty
by that name. It may be worth while, even
at the risk of tedium, to point out that this concept
of “overproduction” applies, not to the material,
mechanical bearing of the situation, but to its pe-
cuniary bearing. The notion is never seriously
entertained that there is or may be an embarrassing
excess of goods, or of the appliances for their pro-
duction, above what would be of some human use
if the business situation permitted them to be
turned to use.

(1) The supply of consumable goods is, practi-
cally, never greater than the community’s capacity
for consuming them. An embarrassing excess in
any line is practically a remote contingency at the
most.’ There are many eloquent passages in the
economic manuals which may be called in witness
of this truism, where much pains is taken to show
that human wants are, in the nature of the case,
indefinitely extensible. Nothing stands in the
way, we are told, but “difficulty of attainment”
of the goods with which to satisfy these wants.
(2) In times of depression, or “hard times,” there

1 Something that might bear such a construction occurs, e.g., locally,
when a run of fish exceeds the ability of the workmen to take care of
them. The fatuity of appealing to such an example is plain.

216 THE THEORY OF BUSINESS ENTERPRISE

is, under the modern industrial system at least, no
overproduction in the sense of a production so
large as to overtax the working capacity of the
industrial appliances and processes employed, nor
so large, even, as to overtax the normal powers of
the force of workmen or require them to work
overtime and holidays. Quite the contrary. That
sort of thing happens only in brisk times, when
there is no overproduction. Seriously to recite
such platitudes as these may seem like a trifling
with the patience of the printer, or it may be taken
for a light-headed excess of “ wissenschaftlicher
Methode”; but these two formulations appear to
cover all the conceivable ways in which overpro-
duction may occur, so long as the term is construed
from the poimt of view of the mechanical facts of
the case. Seen from this side a period of depression
is a period of underproduction; mills run on half
time or none, and the supply of goods that finds
its way into the hands of consumers is sensibly
scant for the demands of comfort.

The difficulty is, of course, a pecuniary one, and
the phrase is used by business men in that pecun-
lary sense in which it has an immediate bearing
on business. “Excessive competition” is an alter-
native phrase. There is an excess of goods, or of
the means of producing them, above what is expe-
dient on pecuniary grounds, —above what there is
an effective demand for at prices that will repay

THE THEORY OF MODERN WELFARE 217

the cost of production of the goods and leave
something appreciable over as a profit. It is a
question of prices and earnings. The difficulty is
that not enough of a product can be disposed of at
fair prices to warrant the running of the mills at
their full capacity, or running them at a rate near
enough to their capacity to yield a fair profit. Or,
to turn the proposition about, as business men are
in the habit of doing, there is more of an output
offered than will be carried off at a fair price, —
such a price as will afford fair or ordinary profits
on the investment and the running expenses.
There is too large a productive capacity; there are
too many competitive producers and too much
industrial apparatus to supply the market at rea-
sonable prices. The matter reduces itself to a
question of fair prices and ordinary profits.'

If there is a large volume of outstanding credit
obligations, that will complicate the situation.
There is always a considerable amount of interest-
bearing securities outstanding, and the claims of
these securities have to be satisfied before divi-
dends can be paid on stock, or before profits accrue
to industrial ventures which have issued the secu-
rities. These fixed charges, together with others
of a like kind, narrow the margin from which
profits are derived and increase the handicap
which a season of dull times brings to the business

1 Cf. Smart, Studies in Economics, ch. VII.

218 THE THEORY OF BUSINESS ENTERPRISE

men in charge of industry. At the same time
fixed charges preclude shutting down, except at a
sure and considerable loss. The business men
involved are constrained to go on, and in the ab-
sence of wide combinations in industry they are
constrained to go on at such competitive prices as
to preclude reasonable profits.

The question of fair prices and reasonable
profits has some reference to current rates of in-
terest. A “fair” rate of profits is such a rate as
bears a reasonable relation to the current rate of
interest, although this relation of profits to inter-
est rates does not appear to be a strict one. Still,
there undoubtedly is some reference to the current
rate of interest as a sort of zero line to which
profits should not decline. New investments are
made on the basis of current rates of interest
and with a view to securing the differential gain
promised by the excess of prospective profits over
interest rates.

In a period of depression the aggregate indus-
trial equipment is, notoriously, not running at its
full capacity ; there are many idle and _ half-idle
plants and many idle workmen. The concerns in
question find themselves unable to do a full run of
business at reasonable profits. Still, unless the
depression is of exceptionally short duration, there
is always some new investment going on. More
or less of new capital continues to find its way

THE THEORY OF MODERN WELFARE 219

into industrial business in competition with the
concerns that are already in the field! In case of
a protracted depression the aggregate of new in-
vestments so made may, in the course of years,
amount to a very considerable addition to the
industrial outfit, and the production of the new
establishments may very appreciably increase the
aggregate output. Indeed, the output of the new
establishments is a notable factor in swelling the
supply and keeping down prices. But the new
investments made during the depression are profit-
able, at least at the start. Or even if this should
be questioned when stated in this broad way, it
will at least hold true that they are commonly
entered upon with a well-advised expectation of
their being profitable if the situation does not ma-
terially change between the time when the new
venture was entered upon and the time when the
new equipment has got under way. If the interval
between the inception of the new enterprise and
its completion is a long one, the situation may so
change in the meantime as to leave it unprofitable
even if it has been conservatively planned. There
are also, of course, fraudulent enterprises which
are not expected by their promoters to pay a profit
on the investment; and there are probably, also,

1 For the present purpose a concern which passes through a liqui-
dation and reappears with a rerated and reorganized capitalization and
body of liabilities also has much of the character of a new investment.

230 THE THEORY OF BUSINESS ENTERPRISE

always some ventures entered upon during dull
times with a view to being beforehand in prepara-
tion for better times. But after all has been said
in qualification of the main proposition, it remains
true that some new investment is going on with a
well-advised expectation of reasonable profits on
the basis of current costs, prices, and rates of
interest.’

The rate of interest in times of depression may
be unsatisfactory to lenders; it may be discourag-
ing by comparison with the customary range of inter-
est rates during better times. Still, the obstacle to
business is not to be sought in an effectual dis-
couragement of lenders, for in point of fact money

1Cf. L. Pohle, Bevilkerungsbewegung, Kapitalbildung und perio-
dische Wirtschaftskrisen, who concludes that depression is due to a
scarcity of capital as compared with population ; the rate of increase
of capital is conceived to fall short of the rate of increase of population,
hence periodical depression.

Cf., on the other hand, Macrosty, Trusts and the State, p. 138, who
finds, by recourse to the testimony before the Royal Commission on
the Depression of Trade and Industry, that there is at such times
capital constantly seeking investment and entering into competition
with what is already invested. Cf. Final Report of the Royal Com-
mission on Depression of Trade and Industry (1886). ‘The replies
received from Chambers of Commerce to the inquiries we addressed to
them confirm the statements made by the witnesses who appeared
before us. Those replies testify to the general maintenance or increase
of the volume of trade, accompanied in many cases by a shrinkage in
its value, and in all cases by a serious diminution of profit. They also
show how general is the belief in commercial circles that overproduc-
tion, the fall of prices, and more effective foreign competition, assisted
by high tariffs, go far to account for the existing position of trade

and industry in this country’ (pp. ix-x). Cf, also pp. xi-xy of the
Report.

THE THEORY OF MODERN WELFARE 22]

is readily to be had on good security during any
protracted depression.’ There is also the fact that
investment is continually going on, which argues
that the difficulty is neither that capital cannot be
found for investment, nor that investment has no
prospect of reasonable profits. Practically, no ex-
ceptional amount of fluent funds is withheld from
the market, — except in time of panic, which is
another matter. It may be added that the rate of
interest need not be notably low in time of depres-
sion, just as, on the other hand, a period of busi-
ness exaltation is not uniformly accompanied by
a notably high rate of interest.

But a low or declining rate of interest is effective
in the way of depressing the business situation,
even though a depression may go on without it.
The line of its bearing upon business depression,
or at least one line, is as follows: Established
business concerns (particularly corporations) en-
gaged in industry have some appreciable fixed
(interest) charges to meet —on leases, mortgages,
and interest-bearing securities (preferred stock and
bonds). These outstanding obligations and securi-
ties may have been negotiated, “floated,” at an
earlier period of higher interest rates and higher
profits, or they may have been carried over through
a period of higher interest rates. In the former

1Cf., e.g., Burton, Crises and Depressions, ch. IV., especially pp,
113-115,

222 THE THEORY OF BUSINESS ENTERPRISE

case these interest charges are excessively high as
compared with the present capitalized value of the
property on which they rest, computing the cap-
italization on the basis of the present cost of
replacing this property and the present interest
charge which this cost of replacement would bear.
In the latter case the original capitalization of the
corresponding items of property will have under-
gone a practical (effective) recapitalization at a
lower figure to correspond with the higher rate of
interest prevalent during the interval in question ;
and in the subsequent period of low interest, the
fixed charge on this recapitalization is excessively
high as compared with the current effective cap-
italization of the property. The liabilities are
excessive, in respect of their interest charges, as
compared with the present earning-capacity of the
property represented by them.’

1 More in detail, what happens in connection with interest-bearing
securities carried over an interval of high interest rates and business
activity may be formulated as follows: When current interest rates
advance, securities bearing a fixed rate (of dividends or interest)
decline on the market. That is to say, the effective capitalized value
of the claim to these fixed rates of income, as shown by the market
quotations, shrinks. At the same time, since the period during which
this readjustment occurs is a period of acceleration in business, the
earning-capacity (actual or putative) of the property on which these
securities rest has increased over what it was at the time the securities
were floated. Hence this property (industrial equipment) is also
recapitalized, in the market quotations, at a higher value than it had
when the securities were floated. The effective recapitalization carried
out by the market quotations acts, for the present purpose, to the same

effect upon the value of both of the items considered, this effect being
to leave a margin of the property previously covered by the securities

THE THEORY OF MODERN WELFARE 223

What gives effect to this drawback for the
business enterprises which have such fixed interest

uncovered and available as collateral on which to flogt a new extension
of credit, in the form of mortgage loan or interest-bearing security.
In the common run of business procedure this available margin,
between the current (higher) capitalized value of the property (collat-
eral) and the current (lower) capitalized value of the securities resting
upon it is promptly covered by a fresh credit extension ; whether this
extension takes the set form of loan, bonds, preferred stock, and the
like, or the less patent form of a larger volume of obligations in the
way of contracts and the like, — the result, as touches the securities
and their basis, being that the same nominal volume of securities with
the same aggregate interest charge rests on a (materially) smaller
block of the industrial equipment after this readjustment of capitali-
zation is had than it did when the securities were placed. When
depression ensues, and the rate of earnings and interest declines, the
effective capitalization of the securities with a fixed rate of income is
increased (if the securities are felt to be secure) to correspond with
the lower rate of interest ; whereas the capitalized value of the block
of industrial equipment on which these securities (plus whatever may
have been added in the interval) rest shrinks to correspond with the
same facts. A discrepancy, such as was adjusted by a recapitalization
during the interval of high rates, reappears, but in the inverse sense.
And this discrepancy cannot be corrected, since the margin on which
the previous adjustment was made has disappeared, and no correspond-
ing margin on the other side emerges. Business accounts do not deal
in negative quantities, except under stress of a necessity that violates
the premises on which business accountancy proceeds.

Recurring to the notation employed on page 153, and letting | = par
value of securities with fixed charges, r=rate per annum of fixed
charges, |’ = market value (effective capitalization) of these securities,

cap! = ea(yp = at v =i;

int
but if int becomes int! (= int +A int), l/ becomes
a is
(int + Aint = int!)
: Aea _ ea!
e same time becomes cap!’ a eS oe aes
et Balas uae + Aint int!’
whereas in a period of falling interest,
lr

int! = int — Aint, and |// = ___—__—______> J,
as vi int! = (int — A int)

224 THE THEORY OF BUSINESS ENTERPRISE

charges to meet is the fact that the new invest-
ments, and those concerns that have gone into
bankruptcy or receivers’ hands, come into com-
petition with the old. These new or rejuvenated
concerns are not committed to a scale of fixed
charges carried over from a higher interest level ;
and these are therefore carrying only such interest
charges as the current effective capitalization of
their property will warrant, whether effective cap-
italization be taken to mean cost of production of
the equipment, earning-capacity of the concern,
or market quotation of its securities. These un-
incumbered competitors are presumed to be making
reasonable profits at current prices, and their pres-
ence in the competitive market therefore precludes
an advance of prices to such a scale as would afford
a reasonable profit to the other establishments after
paying their interest charges on what is, in effect,
overcapitalized property.

This tentative explanation of depression applies
only so far as the period of depression is a time of
relatively low rates of interest. But depression
does not uniformly coincide with low interest
rates; besides which, there are other facts in the
case which limit the applicability of the explana-
tion formulated above. To explain protracted
depression, ¢.g., this line of argument would be
convincing only on the supposition of a progres-
sively falling rate of interest, —a condition not

THE THEORY OF MODERN WELFARE 225

commonly met with in a protracted period of
depression.

But this explanation, applicable within a limited
range of the phenomena that make up a period of
depression, points the way to another class of con-
siderations that go far toward explaining the rest.
It appears that the phase of the difficulty covered
by this explanation is traceable to a discrepancy
between the accepted capitalization, the imterest
charges, and the earning-capacity. And it appears
equally plain that the only remedy applicable to
the case (barring a speculative exaltation of busi-
ness) is a recapitalization of the concerns affected
on a lower basis, to fit the lowered cost of pro-
duction of the equipment and its lowered earning-
capacity. But under existing conditions of law
such a remedy cannot be applied to the interest-
bearing securities, — except by process of insolvency,
—and it is very reluctantly applied to other capi-
talized wealth; besides which it is, practically,
very difficult to effect such an avowed recapitaliza-
tion as applied to the stock of incorporated com-
panies, particularly in the case of those whose
stock is ostensibly the capitalized value of their
plant.

Such a readjustment of nominal value to actual
value as shown by the facts of earning-capacity
is continually going on, in some measure; but it
does not cover the entire range of facts involved,

226 THE THEORY OF BUSINESS ENTERPRISE

and it is nearly always of the nature of a reluctant
concession, following only after the need of it has
become somewhat pressing. It can, therefore, in
the common run of cases, not catch up with the
progressive difficulty which it is designed to meet,
in so far as the difficulty is of a progressive
character.

A discrepancy between accepted capitalization
and current earning-capacity, similar to the dis-
crepancy discussed above but of a progressive
character, arises under modern conditions apart
from a fall in the rate of interest. The discre-
pancy pointed out and provisionally disposed of
above, due to a fall in interest rates, is a discre-
pancy between the nominal value (accepted capi-
talization) of the older establishments, computed on
their earlier earning-capacity or on the original
cost of their equipment, on the one hand, and
their present actual value on the other hand, com-
puted on their current earning-capacity in compe-
tition with rivals that have the advantage of a
lower cost of equipment, or, in other words, a
lower interest charge per unit of earning-capacity.
Under the régime of the later, more fully devel-
oped machine production, a discrepancy having a
similar effect arises out of a persistent divergence
between the past cost of production of a given
equipment and the current cost of a like or equiva-
lent equipment at any subsequent date, — suppos-

THE THEORY OF MODERN WELFARE 227

ing that there intervenes no inflation of prices and
no extraneous cause making for a speculative
advance."

Suppose prices of finished goods to be stable or
to vary by inconsequential fluctuations, negligible
for purposes of the argument, and suppose the
rate of interest to be in a similarly negligible
position. In other words, suppose such a condi-
tion as the business community would recognize
as ordinary, normal, sound, without ground for
pronounced hopes or fears. Under modern cir-
cumstances, dominated as the modern situation is
by the machine industry, such a state of affairs is
unstable, even apart from any disturbance of an
extraneous kind. It is unstable by virtue of the
forces at work in its own process, and these forces,
on the whole, make for a progressive change in the
direction of depression.

It has appeared above that the depressing effect
which a relatively low (declining) rate of interest
has upon industrial business is due to its setting
up a discrepancy between the accepted capitaliza-
tion of older establishments and the cost of new
establishments of an equivalent earning-capacity.

1 Compare Hobson, Problem of the Unemployed, ch. V., and 'Tugan-
Baranowsky, Handelskrisen, ch. I. and VI. In his criticism (pp. 191-
198) Tugan has quite missed the point of Hobson’s theory as well as
of his illustration, having apparently not understood Hobson’s exposi-
tion, which is, in effect, very similar to his own. See also Hobson,
Modern Capitalism, ch. VIL, especially secs. 8 and 16,

228 THE THEORY OF BUSINESS ENTERPRISE

Now, under the circumstances of the more fully
developed machine industry, such as it has stood
for a couple of decades past, a similar discrepancy
results from the gradual but uninterrupted pro-
gressive improvements of industrial processes.
“The state of the industrial arts,’ as the older
economists are in the habit of calling it, is no
longer to be conceived as stationary, even for the
time being. No “ statical”’ theory of the industrial
arts or of business prosperity is tenable, even for
the purposes of a “ statical”’ theory of the dustrial
situation. Progressively increasing efficiency of
the processes in use is a pervading trait of the
industrial situation. No two successive years are
now on the same, or virtually the same, plane in
respect of the efficiency of the industrial arts;
indeed, the “ period of production ” can no longer
safely be construed to begin and end on the same
level in this respect. At the same time the pro-
gressively wider and more close-knit articulation
of the several industries in a comprehensive process
is also going forward, and this also affects all
branches of industrial business in some degree
and in the same direction, as will appear presently.

The items of the equipment (plant, materials,
and in a measure even good-will) in which any
industrial enterprise invests, and by the use of
which the business men in industry turn out their
output of vendible goods, are themselves products

THE THEORY OF MODERN WELFARE 229

of the machine industry. Machine processes, ever
increasing in efficiency, turn out the mechanical
appliances and materials with which the processes
are carried on, at an ever decreasing cost; so that
at each successive step the result is a process hav-
ing a higher efficiency at a lower cost.' This is
now no longer a sporadic effect of ingenious con-
trivances having a local and limited application,
to be handled as trade secrets and exploited as an
enduring differential advantage.

The cost of production of “capital goods”’ is
steadily and progressively lowered, as counted in
terms of the processes involved in their production.
In a competitive market this is reflected, with
greater or less promptitude, in the prices of such
capital goods to all buyers. But the buyers whose
purposes this lower scale of prices particularly sub-
serves are chiefly the new investors who go into
business in the way of new industrial establish-
ments or extensions of the old. Each new venture
or extension goes into the competitive traffic of
producing and selling any line of staple goods
with a differential advantage, as against those that
have gone before it, in the way of a lower scale
of costs. A successively smaller aggregate value
of new equipment will turn out a given volume of

1 The typical form taken by this acceleration is the machine pro-
duction of machinery, but in fact it involves the production of other
material factors as well as the mechanical apparatus, notably the
materials used in industry.

230 THE THEORY OF BUSINESS ENTERPRISE

vendible product. In so far as there is no collu-
sive control of the output or the prices, this means
that the newcomers will cut under the scale of
prices at which their predecessors have been con-
tent to supply the goods. The run of competitive
prices is lowered; which means that at the new
competitive prices, and with their output remain-
ing on its old footing as regards expenses of pro-
duction, the older establishments and processes will
no longer yield returns commensurate with the
old accepted capitalization.’ From the inherent
character of the machine industry itself, therefore,
it follows that the earning-capacity of any imdus-
trial enterprise enters on a decline from the outset,
and that its capitalization, based on its initial
putative earning-capacity, grows progressively an-
tiquated from the start. The efficiency of the
machine process in the “instrumental industries”
sets up a discrepancy between cost and capitali-
zation. So that a progressive readjustment of
capitalization to correspond with the lowered earn-
ing-capacity is required by the nature of the case
It is also, in the nature of the case, impracticable.

1 The established concerns having been capitalized on the basis of

past cost, we can say that in the older establishments, cap =f (cost),
but in the new establishments with an equal earning-capacity, cap; =

~ } S
f (cost; = cost — A cost); hence the rate of earnings [=/ el

will be progressively higher as cost decreases : —

ea ea ea
f\— —_—_—__—$___- —_______—_ }, et.
y ee 1 een —A al nt (ee —2A = ;

THE THEORY OF MODERN WELFARE 231

Tn so far as the process of investment and business
management involves the use of credit, in the way
of interest-bearing securities or loans equivalent to
such securities, this element of credit retards the
readjustment by force of the fixed charges which it
involves. This retardation (aided as it is by the
reluctance of business men to lower their capitali-
zation) is of sufficient effect to hinder recapitaliza-
tion, on the whole, from overtaking the progressive
need of it, with the result that a fair or “ordinary ”
rate of profits on industrial investments is not per-
manently attainable in the field of open competi-
tion. In order that the rate of interest should
effectually further business depression in this way,
therefore, it is not necessary that the rate should
rise or fall, or that it should be relatively high or
low, or that it should be uniform over the field,
but only that there should be a rate of interest in
each case, and that there should be some appreciable
volume of credit involved in industrial investments.
Credit is, in fact, a ubiquitous factor in modern
industrial business, and its effects in the way
indicated are therefore to be counted in as a
constant force in the situation.

However, even apart from the presence of this
ubiquitous credit element, a similar effect would
probably result from the progressive enhancement
of industrial efficiency when this enhancement pro-
ceeds at such a rate as has been the case for some

232 THE THEORY OF BUSINESS ENTERPRISE

time past. As has been shown in an earlier
chapter, business men keep account of their wealth,
their outgo and their income, in terms of money
value, not in terms of mechanical serviceability or
of consumptive effect. Business traffic and busi-
ness outcome are standardized in terms of the
money unit, while the industrial process and its
output are standardized in terms of physical
measurements (mechanical efficiency). In the cur-
rent habits and conventions of the business com-
munity, the unit of money is accepted and dealt
with as a standard measure. The stability of the
standard unit cannot be effectually questioned
within the scope of business traffic. According to
the practical metaphysics of the business com-
munity, the money unit is an invariable magnitude,
whatever may be true of it in fact. A man
imbued with these busmess metaphysics and not
given to fine-spun reflection, as business men com-
monly are not, is richer or poorer in his own
apprehension, according as his balance sheet shows
a greater or less number of these standard units of
value. Investment, expenses, vendible output,
earnings, fixed charges, and capitalization run in
terms of this value unit. A reduction of earnings
or of capitalization, as rated in terms of the value
unit, is felt as an impoverishment. The reduction
of capitalization in these terms is, therefore, a hard-
ship, which is only reluctantly and tardily submitted

THE THEORY OF MODERN WELFARE 233

to, even if it carries no hardship in the way of a
reduced command over the material means of pro-
duction, of life, or of comfort. A business man’s
rating in the business community likewise rests on
the pecuniary magnitude of his holdings and his
transactions, not on the mechanical serviceability of
his establishment or his output; and this business
rating is a large part of the business man’s every-
day ambition. An enhancement of it is a source of
secure gratification and self-respect, and a reduction
of it has a very substantial contrary effect.’ A reduc-
tion of the pecuniary showing is submitted to only
reluctantly and tardily, after it has become unavoid-

1 Recurring to the notation employed in note 2, page 168, and letting
Um= unit of material efficiency, then a given established concern, A,
with a given equipment U,(cap)a<U.(cap) = U,(cap) = U.( a)
presently finds itself in competition with a younger concern, B, having
an equivalent material equipment = U,,(cap), procured at a lower cost
and requiring lower earnings (= ea!) and lower fixed charges.

Un(Cap)o= Ue = oral = U,(cap!= cap — Acap).
int int

But Un(cap)a= Un(cap), as competitors in the market. Hence, with
the competitive lowering of earnings, and therefore of effective capitali-
zation, A’s account comes to stand : —

Um(Cap) a= U.(cap!) = U.(cap — Acap) < U, (cap).
In effect A is overcapitalized by U.(cap — cap’). A’s nominal capital,
Un(cap)a~U,(cap!+A cap), while A’s effective capitalization

U.(cap!)a= U.(cap — A cap).

The business man’s sensibilities in the case, therefore, suffer a lesion

ea ea — Aea
=f | t(j) -™( int )}
which is a monotonic function. The discrepancy between U,(cap), and
U.(cap’) is, in large part, embodied in securities with fixed charges ;
which makes a readjustment very difficult even apart from A’s
reluctance,

934. THE THEORY OF BUSINESS ENTERPRISE

able, and only to the least feasible extent. But under
conditions, such as now prevail, which involve the
requirement of a progressive rerating of this kind,
this reluctant concession never overtakes the need of
readjustment, — and the discrepancy between capi-
talization and earning-capacity is therefore chronic
so long as no extraneous circumstances come in
temporarily to set aside the trend of busmess
affairs in this respect. It may, therefore, be said,
on the basis of this view, that chronic depression,
more or less pronounced, is normal to business
under the fully developed régime of the machine
industry.'

This deplorable trend given to business by the
excessive prevalence and efficiency of the machine
industry can, however, be set aside by several
factors more or less extraneous to the industrial
system proper. Hven within the mechanical sys-
tem of industry there is at least one factor of some
consequence that consistently acts to mitigate the
trend indicated, and that may even put it in abey-
ance from time to time. As has been pointed out
above, questions of business are fundamentally
questions of price. A decline of prices which

1 With the above analysis may be contrasted Marx’s discussion
of the declining rate of profits and the manner in which he conceives
overproduction, speculation, and crises to arise out of the tendency of
profits toa minimum. (Kapital, vol. III. ch. XV.) In the same con-

nection, see Tugan-Baranowsky’s criticism of Marx, Handelskrisen,
ch, VIL

THE THEORY OF MODERN WELFARE 235

widely touches business interests brings depression.
Conversely, an appreciable advance in prices, from
whatever cause, means improvement in business.
Such an advance in prices may come of a specula-
tive movement; which in turn may arise from a
variety of circumstances, for the most part circum-
stances extraneous to the industrial process. For
the present, however, the question of a speculative
movement is best left on one side. Another factor
touches the case more intimately. As has more
than once been the case, prices may be advanced
through a freer supply of the precious metals, or
by an inflation of the currency, or a more facile use
of credit instruments as a subsidiary currency
mechanism. Now, the growing efficiency of in-
dustry has an effect in lowering the (material) cost
of production of the precious metals and so in-
creasing the ease with which they are supplied,
after the same manner as it affects the supply of
goods for industrial or consumptive use. But the
increased supply of the precious metals has, of
course, an effect upon prices contrary to that ex-
erted by the increasing supply of goods. In so far
as this effect is had, it acts to correct or mitigate
the trend of business toward chronic depression.'
1JIn point of direct material serviceability, no doubt, a fresh supply
of the precious metals is one of the least useful forms of wealth to
the production of which industrial effort can be directed, but for the

purposes of business prosperity at large it is probably the most service-
able addition that can be made to the aggregate wealth. Rapidly

236 THE THEORY OF BUSINESS ENTERPRISE

But certain circumstances come in to qualify the
salutary effect of a lowered cost of the precious
metals. Improvements in the industrial processes
affect the (industrial) cost of production of the
precious metals in a less degree than the cost of
other goods; at least, such seems to have been the
case recently. But beyond this, and of graver
consequence, is a peculiarity affecting the value of
the money metals. The annual product of the
money metals is not annually consumed, nor nearly.
The use of them as money does not consume them
except incidentally and very slowly. The mass of
these metals in hand at any given time is very
considerable and is relatively imperishable, so that
the annual accretion is but a small fraction of the
aggregate supply. The lowered cost of the annual
supply has therefore but a relatively slight effect
upon the aggregate value of the available supply.

The case is different as regards the annual out-
put of vendible products, whether for industrial or
consumptive use. In this case, and particularly as
regards this matter of new investments and exten-
sions of industrial equipment, the annual output
counts for by far the greater factor in making the
current value of the available supply, if indeed it
increasing efficiency in the production of other forms of wealth is detri-
mental to the business interests, in that it brings depression ; but a
rapid increase of the precious metals is the most fortunate material

circumstance for the business interests that industrial activity can
bring, because it puts off depression by keeping up prices.

THE THEORY OF MODERN WELFARE 237

is not to be regarded as substantially the only
factor that comes in question here. Accordingly,
it is only under very exceptional circumstances, at
times when the precious metals are supplied with
extraordinary freedom, that the increased output of
these metals can offset the trend of business toward
depression. Ordinarily this factor can count for
no more than a mitigation of the “tendency of
profits toa minimum.” And even this mitigating
effect, it may be remarked, appears to be of less
radical consequence for the general situation of
business now than it was during the earlier phases
of the machine industry’s régime. The most telling
effect of an increased supply of the precious metals
seems to be the incitement which it gives to
speculative inflation."

It will be noted that the explanation here offered
of depression makes it a malady of the affections.
The discrepancy which discourages business men is
a discrepancy between that nominal capitalization
which they have set their hearts upon through
habituation in the immediate past and that actual
capitalizable value of their property which its cur-
rent earning-capacity will warrant. But where
the preconceptions of the business men engaged
have, as commonly happens, in great part been

1 Cf, Smart, Studies in Economics, Essay VI., ‘‘ Must Prices Fall ?”’
Distribution of Income, bk. II, ch, TI.

238 THE THEORY OF BUSINESS ENTERPRISE

fixed and legalized in the form of interest-bearing
securities, this malady of the affections becomes
extremely difficult to remedy, even though it be
true that these legalized affections, preconceptions,
or what not, centre upon the metaphysical stabil-
ity of the money unit.

But while it is true that depression is primarily
a business difficulty and rests on emotional grounds,
that does not hinder its having grave consequences
for industry and for the material welfare of the
community outside the range of business interests.
Business enterprise, it is true, proceeds on meta-
physical grounds and is swayed by considerations
of nominal wealth rather than by considerations of
material serviceability ; but, none the less, business
enterprise and business metaphysics control the
course of industry.

Dull times in business means dull times in in-
dustry, of course. But a caution is necessary on
this head. The yearly output does not usually
vary extremely between brisk and dull times,
except as measured in price. As measured in
material terms the discrepancy in the volume of
output between brisk and dull times is much less.
The gross output as measured by weight and tale
is less in dull than in brisk times, other things
equal; but the deficiency as measured in these
terms is much less than the price returns would
indicate. Indeed, the output as measured by

THE THEORY OF MODERN WELFARE 239

weight and tale need not average very appreciably
less during a protracted depression than during a
preceding period of good times.'. The volume of
business as well as the volume of output (by weight
and tale) of industry may increase during a few
years of depression at nearly if not quite as high a
rate as during a corresponding period of good
times. A transition from dull to brisk times, how-
ever, commonly if not invariably involves a rapid
increase in values, while a converse transition
involves a corresponding shrinkage of values,
though commonly a slower shrinkage, — except
where a crisis intervenes.

The primary hardship of a period of depression
is a persistent lesion of the affections of the busi-
ness men; the greatest secondary hardship is what
falls upon the workmen, in the way of partial
unemployment and a decline in wages, with conse-
quent precariousness and reduction of their liveli-

1 Work goes on during dull times, though at a slackened pace, and
extensions and improvements are continually being made. The volume
of output consequently increases, so that, even if there has been a set-
back to production at the beginning of the depression, the aggregate
output presently again reaches the volume which it had when the
dull times set in. It may be added that the rate of consumption is
also appreciably lower during dull times, particularly in the more
wasteful forms of consumption. This lowered aggregate consump-
tion offsets the lowered intensity of production during dull times to
such an extent that it is probably safe to say that the net sur-
plus product, measured by weight and tale, is at least not appreci-
ably smaller during depression than during prosperity. Cf. Carroll