Hawtrey's Economics
Macroeconomic cycles were the focus of Hawtrey’s analysis throughout his career: what caused them and how to prevent them or how to mitigate their consequences. One of the key conclusions was that ‘the trade cycle is a purely monetary phenomenon’ (Hawtrey 1923: 141). Good and Bad Trade dealt with the trade cycle and advanced a perspective that, while it evolved and was elaborated and applied to historical and contemporary issues, remained at the core of Hawtrey’s subsequent work. In 1937, he told Keynes,
I have adhered consistently to my fundamental ideas since 1913 and in so far as they have developed and grown the process has been continuous since then ...
I do not think this conservatism is a merit; indeed I should rather like to go in for something novel and extravagant if I could be convinced of it (Hawtrey quoted in Keynes 1973a: 55).
Looking back from the early 1960s, Hawtrey reported that he had started working on Good and Bad Trade in March 1909. He had become interested in the trade cycle and cited official reports and his own observations as the genesis of his thinking:
It struck me that the extinction of profit could be explained if the price level fell in the interval between the incurring of costs and the sale of the product. And if traders borrowed at interest to finance profit-making business, they could pay a higher rate of interest when prices were rising and a lower rate when prices were falling. A falling price level makes a given market rate of interest more onerous, and a rising price level less so. Here, I thought, was a discovery, but I was disillusioned when I learnt from an economist friend that the principle was one already recognized, and had been expounded in Irving Fisher’s work (Hawtrey 1962a: vii).
The ‘economist friend’ was, in all likelihood, Keynes.
The most complete development of Hawtrey’s model can be found in Currency and Credit, which went through four editions and was widely used as a text in money and banking courses in the 1920s and 1930s.
An understanding of the dynamics of an economy required starting from a model of a monetary economy with flows of income and output based upon credit and expressed in monetary terms. The first chapter of Currency and Credit began with consideration of an economy based on ‘credit without money’ (Hawtrey 1919 [1928]: 1-16). Transactions of all sorts result in the creation of debts and offsetting credits for the buyers and the sellers. Institutions such as banks can arise to provide mechanisms to clear debts. A unit of account must arise so that different sorts of transactions and the debts to which they give rise can be set off against each other. That is one of the services that money can provide.
The demand for a stock of the means of settling debts depends primarily on the level of incomes. Each person ‘would keep some unexhausted credit in hand to meet the payments, foreseen or unforeseen, which will have to be made in the near future’ (ibid.: 7). In Hawtrey’s unique terminology, these balances were sometimes labelled the ‘unspent margin’ because they increased or decreased depending on the difference between consumers’ income and consumers’ outlay.
Consumers’ income and outlay were the categories that Hawtrey developed to analyse the circular flow of income, expenditure, and production:
An increase or decrease in people’s (nominal) incomes will lead to an increase or decrease in their (nominal) expenditures ... Only true income and final expenditure are to be counted; expenditure on the production or purchase of goods for subsequent sale is to be excluded. The income is to be what a man has available to spend on his own needs; the expenditure is to be what he so spends. They may conveniently be called the ‘consumers’ income’ and the ‘consumers’ outlay,’ though it must be understood that ‘consumer’ includes ‘investor,’ for investment is one of the purposes on which income may be spent.
The receipts and disbursements of the trader, who buys or produces with a view to sale, may be called the ‘trader’s turnover’ ... The trader.gets his true income out of the profits of his business, and this figures in the total of the consumers’ income (ibid.: 45—46).
Economic activity in Hawtrey’s analysis pivots around dealers. Dealers hold stocks of goods that they order from primary producers, manufacturers, or other dealers. They sell from these stocks to retailers or other dealers. In Hawtrey’s model, dealers possess a uniquely strong ability to judge the state of markets and make the decisions that, in the aggregate, speed or slow the pace of economic activity.
Dealers are also particularly sensitive to changes in short-term interest rates. A mutually beneficial relationship arises between dealers and bankers. Hawtrey characterized bankers as ‘dealers in debt’ (ibid.: 4). Inventories are excellent collateral for loans from banks. As a result, dealers are able to finance their inventories with short-term loans on comparatively favourable terms, that is, in comparison to financing with their own capital or with longer-term borrowing.
For many of Hawtrey’s contemporaries, it was fixed capital formation which played the central role in the trade cycle. Cycles in capital goods-producing industries were observed to be especially pronounced. Hawtrey acknowledged this and even in Good and Bad Trade developed an accelerator mechanism to account for it. He started from an assumption of an industry growing at a steady pace of 1% a year and replacing 5% of its capital stock each year. Gross investment is equal to 6% of the initial stock in the steady state. If the capital-using industry’s growth rate increased from 1% to 4%, then the output of the capital-producing industry would need to rise by 50%, from 6% to 9% of the initial stock. This demonstrated that the greater cyclicality of capital-producing industries could be a consequence rather than a cause of fluctuations in consumers’ income and outlay. Hawtrey acknowledged that exogenous shocks to fixed investment could be the source of macro fluctuations, but he argued, first, that these could not account for the regularity of trade cycles before the First World War and, second, that these shocks could still be countered by monetary policy, operating primarily through short-term interest rates.
A central bank is able to determine short-term interest rates in the economy because of its power to lend funds or buy assets to an unlimited extent. To raise interest rates generally the central bank raises the terms on which it makes loans available. Usually the change in Bank rate alone would be sufficient to affect the demand for loans and economic conditions. If more were needed, Bank rate could be reinforced by buying or selling other financial instruments. By selling government bonds or other debt instruments, the central bank lowers their prices and raises their yield while drawing liquidity from the market. To lower interest rates it reverses the process, offering to lend at a lower rate than previously and buying bonds and other debt instruments, raising their price and lowering the yield while adding liquidity. The decisions made by the central bank depend on the monetary regime in place and on policy goals.
In the 1930s, Hawtrey developed the concepts of widening and deepening for the analysis of fixed investment. Widening is investment that takes the form of expansion of a business with no change in the amount of capital per unit of output. It is motivated by opportunities for profit. Deepening is investment that increases the amount of capital per unit of output. The longterm rate of interest would determine how far to push investment in capital per unit of output. However, Hawtrey expected the relationship to be loose because the response of fixed investment would be constrained by uncertainty about future demand and factor prices and by discontinuities in the marginal yield of capital.
The central bank’s direct power is over short-term nominal interest rates. From the outset Hawtrey distinguished between nominal and real interest rates. In Good and Bad Trade, he defined the profit rate of interest as the natural rate of interest plus an allowance for changes in the price level: ‘Competition always tends to make the rate of interest prevailing in the market equal to the actual yield expected from the use of money in business’ (Hawtrey 1913: 45-46). The long end of the term structure is less amenable to central bank power and its impact on fixed investment decisions, to which many of Hawtrey’s prominent contemporaries gave primary importance, was uncertain and highly variable in comparison to the responsiveness of dealers’ demand for stocks of goods to changes in the short-term rate at which they could borrow.
Under a gold standard, with a country’s money legally convertible to gold at a fixed rate, the maintenance of a gold reserve adequate to meet any conceivable demand was the primary driver of central bank policy. Throughout much of Hawtrey’s career the tribulations related to gold—the piecemeal return to gold after the First World War, maintaining the gold standard under conditions of high unemployment after the return, and, abandoning gold during the Great Depression—were dominant issues.
In Hawtrey’s analysis, the monetary economy does not settle into a stable equilibrium or growth path. One of his key themes was ‘the inherent instability of credit’ (Hawtrey 1932: 166-174). Left to itself, credit would tend to expand without limit once an inflationary path was in motion. Similarly, there was no built-in limit to deflation. Nor is adjustment to lower prices or a path of falling prices smooth. Prices, including wages, are lowered only under sustained pressure from falling sales, reduced orders and production, and rising unemployment. A gold standard provides an anchor, though a very imperfect anchor, because bankers respond to the loss of reserves that comes about from an overly expansionary policy by raising lending rates and to an increase of reserves by lowering rates and otherwise making credit more readily available. Because the adjustments take time this tended to create a credit cycle. The cycle was fairly predictable when it was not punctuated by major events such as the discovery of new mines or periods of war when combatants abandoned gold.
Gold itself offered only a flawed foundation for money because the ‘wealth value’ of gold itself varied. For example, growing monetary demand for gold that outpaced increased supply could lead to a tendency to deflation on the gold-using world. This was precisely the situation expected following the First World War.
Hawtrey had great confidence in the ability of monetary authorities to mitigate the instability of credit through skilful and timely adjustment of Bank rate. However, in practice central bankers were apt to make mistakes and did not themselves either recognize or acknowledge the power that he ascribed to them. Failure to move promptly to counter a deflationary tendency could lead to ‘trade deadlock’ (Hawtrey 1933: 29), a situation in which interest rate cuts would fail to stimulate the new borrowing that would turn the situation around. Under these circumstances, other tools to increase the flow of income and outlay, including debt-financed public works, were called for.
Hawtrey is identified with the Treasury view, the position that public spending simply displaces private spending and would have no impact on aggregate economic activity. He developed this case in the most complete way in his 1925 paper ‘Public Expenditure and the Demand for Labour’. Public spending was only effective if it was a vehicle for credit expansion and, considered that way, it was an inefficient means to the end of increasing employment and economic activity: ‘The public works are merely a piece of ritual, convenient to people who want to be able to say that they are doing something, but otherwise irrelevant’ (Hawtrey 1925: 44).
He had argued against public works in Good and Bad Trade. There he wrote in response to the 1909 Minority Report of the Poor Law Commission proposal that a portion of public expenditures on capital formation be triggered when the level of unemployment breached a target level. The funds required would be deficit-financed and Hawtreys view was that ‘the writers of the Minority Report appear to have overlooked the fact that the Government by the very fact of borrowing for this expenditure is withdrawing from the investment market savings which would otherwise be applied to the creation of capital’ (Hawtrey 1913: 260). In the Foreword that he wrote in 1961 to a reprint of the book he acknowledged that this ‘failed to take account of the possibility of the expenditure having a deliberately inflationary character’ (Hawtrey 1962a: ix).
It seems likely that Hawtreys scepticism of public works emerged in part at least from the native hostility of a Treasury official to spending public money and adding to public debt when the net benefits of the spending are doubtful. In later years, he was happy to take the credit or the blame for authorship of the Treasury View (Deutscher 1990a).
A significant part of Hawtreys theoretical and practical work was concerned with foreign exchange markets. Markets for foreign exchange, like all markets in Hawtrey’s analysis, are operated by dealers. The economy itself is divided between sheltered and unsheltered industries, sometimes using the terminology of home-trade products and foreign-trade products. Sheltered industries produce only for the home market and are protected by natural barriers from foreign competition. Unsheltered industries compete in global markets whether their products are bought domestically or are exported. Their products are effectively priced in world markets. Hawtrey in various writings described the mechanisms leading towards equilibrium between the external and internal price level and the distribution of resources between sheltered and unsheltered industries.[1]
- [1] See, for example, Trade and Credit, pages 23—24, or Bretton Woods for Better or Worse, pages 86—88, orChapter 5 of Currency and Credit.
