§ 13. PSYCHOLOGICAL FACTORS.

In an economic system which is based on the free decisions and economic conduct of millions of individuals the fluctuations of mind underlying these decisions must be of decisive importance for the equilibrium of the economic system, and the question arises whether the phenomena of economic oscillations do not depend in the last analysis on such fluctuations in mass feelings and opinions. An affirmative answer to this question is given by the theory of the trade cycle of the psychological school.⁷ There is much that this theory can count in its favour, especially the important circumstance that the upward swing of the cycle is characterized by a feeling of general optimism and the downward swing by one of general pessimism, and that the one is carried just as far in the upward direction as the other is in the downward direction. In every cycle the experience repeats itself with wearisome regularity, that in the boom people seem to trust to the eternal duration of prosperity, while in the depression they are seized with a dismal melancholy bordering almost on a feeling that the end of the world is approaching. They speak of the “end of capitalism” and forget that up till now every depression has none the less come to an end. It is a case of a mass mental epidemic which only very few are able to withstand, while the vast majority are carried away by the power of suggestion of popular feeling. This is what is in the main at the back of speculative extravagances on the stock markets in which people eventually lose touch with every real foundation of fact. In describing this frenzy, Lavington has compared people to boys who tread on a surface of ice on which there are already many people skating and are given courage by the very fact that there are already so many others on the ice, although the danger that the ice may break increases with the increasing number of the skaters. If a speculative price movement sets in on a market, it tends to be accentuated in a vicious circle and driven to excess. This is as true of the upward movement as of the downward one, so that the French saying: “La hausse amène la hausse” can be equally well applied to the “baisse.” If, for example, the public, frightened off and disheartened by security losses in the crisis, has turned away from the security market, then the desertion of the stock exchange is likely to intensify the lack of disposition towards investing savings in securities. This in turn presses on the whole economic situation and thereby strengthens the real grounds for the depressed state of security prices.

The psychological factor is particularly important in connexion with fluctuations in investment activity which in fact constitute the essence of the cyclical movement. In accordance with the very nature of transactions directed towards the uncertain future, they are dependent in special measure on subjective estimates, that is, estimates highly liable to error, and on the average level of confidence. The snowball-like growth or decline is strengthened all the more by the fact that the increase in investment by one entrepreneur induces investment by another entrepreneur not merely because he is affected by the more optimistic mood, but also because more orders now fall to his lot. For the depression the opposite is true. As a rule the force of competition leaves no choice to the entrepreneur but to swim with the stream. He dare not be the first to restrict his business undertakings in anticipation of an over-production and over-speculation: he always calculates that another will take the lead in this direction with the result that nobody does so. This is only human and it would be surprising to find it otherwise.

People take part in the ups and downs of popular feeling not only as entrepreneurs but also as savers and consumers. In the boom they confidently put their savings in the illiquid form of securities and mortgages while in the depression they hold them mistrustfully on demand deposit at the banks, or even, if the mistrust has reached its peak and spreads even to the capacity for payment of the banks themselves, withdraw them and keep them in the form of cash (possibly even in gold as has recently been the case in France). As consumers, they are prepared in the boom to convert their money rapidly into goods, while in the depression they buy only very hesitatingly in the expectation of a further fall in price. The conduct of both saver and consumer has the effect, via its influence on the liquidity of the banks and via changes in the velocity of circulation of money, of intensifying both the boom and the depression.

Lastly, it is of special significance that the bankers themselves are also subject to the psychological ebb and flow. So it is that in the boom, infected by the general ardent optimism, they loosen the reins of their credit policy, sift less strictly the demands for credit, look less fastidiously at collateral, overestimate the productivity of the credits they grant and are satisfied with less liquidity. In the depression the memory of the sins of the boom, and the “frozen credits” with which they atone for these sins, cause the banks to fix the most extreme requirements for their liquidity and to subordinate to this all other considerations.

It is true of all these psychological factors that they could not reach such large proportions if the uncertainty about economic data, the defectiveness of economic information (which is again closely bound up with competitive considerations), and the uncertainty of the future did not give wide scope for mere presumptions and vague predictions highly coloured by sentiment, and for errors of all kinds. But, even for facts that are to a certain extent definite, the saying of a Greek philosopher is true that it is not the facts that determine human action but the opinions about the facts.

Nevertheless the reference to psychological factors cannot give a satisfactory explanation of cycles and crises. A theory which imputes the change from boom to depression to mere fluctuations of feeling and to mistakes, prejudices itself by its very simplicity when we consider the complicated nature of economic fluctuations. It fails in fact to give satisfactory answers to many vital questions. How, for example, does this rhythmical oscillation from optimism to pessimism, from activeness to lethargy, come about? Is it conceivable that mere mass feelings and mass mistakes cause real changes in the spheres of goods and money such as characterize the movements of the trade cycle? Is it imaginable that these mass psychological phenomena would last so long if there did not lie at the root of them real events from which they took their origin and which are continually giving them new force? Why does the psychological rhythm not repeat itself from month to month instead of spreading over years?

A satisfactory theory of cycles and crises cannot be content with merely describing the admittedly exceedingly important psychological events which are to be observed during the movement of the cycle, any more than fluctuations in the value of money can be adequately explained by referring to the factor of confidence without showing at the same time how this factor relates to the final determinants of the value of money—the quantity of money, the velocity of circulation of money, and the volume of goods. In the same way, price theory cannot be content with the mere statement that the ultimate forces behind price formation are the feelings, calculations, moods, and decisions of human beings; its task is rather to show the basic rules according to which these forces work. It is the same with the theory of cycles and crises. It must always take into account that it is the judgments and decisions of human beings that move the economic process and it has to have regard to all anomalies, errors, and mass mental epidemics to which human beings may be subject, to describe their origin and to analyse their repercussions. But it cannot stop here. Its real task consists in showing how these psychological events connect up as a whole with the real facts of economic life, what disturbances there may arise in this manner in the structure of production, in the income structure, in the banking system, and in the structure of costs and prices. This is not to deny that psychological factors can in certain circumstances play a very active and independent role, as in overcoming the pit of the depression, or in magnifying the forces of expansion, or, lastly, in entangling the economic system in the net of a progressive depression. The last case is exemplified particularly forcefully by the present situation all over the world.

We see now more clearly than ever before that our economic system—like any other, including the Russian—rests, in the last analysis, on certain psychological reserves without which it ceases to work, in spite of its glorious technique and organization. Formerly, this requisite appeared so obvious that people did not think it necessary even to mention it, for they hardly contemplated a state of affairs in which it did not exist. It would almost seem as though the fact had been forgotten that the psychological—especially the moral—forces behind any economic system are the centre upon which everything else hinges, and that the most elaborate technical apparatus is of comparatively little significance if the electric current of these forces has been switched off. In fact, the gigantic apparatus of our economic system is absolutely dependent on an invisible network of psychological forces and relations between the individuals, between the individuals and the community, and between the individuals and their material environment. It cannot exist without confidence—in other individuals, in the State and its legal order, and in the future in general—without some possibilities of and inducements for making preparations for a more distant date than the immediate present, without a link between the present and the future, nor even without some ideology—or, indeed, a creed in the most general sense. Nor can it exist without an atmosphere of peace, liberty, and reason. Our economic system has multiplied the economic productivity of the world by mobilizing all moral and intellectual forces on an unprecedented scale and this is the real secret of its enormous success. But, on the other hand, it is also dependent on the existence of a minimum of these forces, otherwise it is bound to decay. That is the lesson which the present depression is teaching us. Hence, we cannot help feeling deep sympathy with the general trend of ideas of the psychological school.