An unavoidable element of risk enters into all modern business. In the
old handicraft stage of industry goods were made upon order; demand
preceded supply very definitely, and there was little possibility of
mistakes in production. Nowadays, as we have seen, production is for a
distant and often uncertain market. It is carried on by machine
methods and roundabout processes; sometimes the result is a very
remote one and the uncertainty of success is correspondingly great.
Production is not based upon order, but upon a forecast of the
possible demand, upon a future market. Chance and change are
inseparable from productive enterprise--natural chances from the
elements, political changes, as war or unfavorable legislation,
industrial mistakes or sickness or death of oneself or others, and
economic changes, as the invention of a new machine or a change in
fashion. These are the unavoidable incidents in industry and are not 52
under the control of the individual business. Some of them, however,
are so regularly recurrent that they can be foretold on a large scale
for any industrial society, and can be guarded against by insurance.
Everyone recognizes the desirability of having such risks as those of
fire, shipwreck, lightning, death, etc., assumed by certain
individuals or companies who make a business of such risk-taking. A
small premium is paid by the individual for protection, and he is
freed from anxiety from mischance and is able to devote his whole
energies and capital to his business; the insurance company has
specialized in this one department and by equalizing the chances over
a wide field has practically eliminated them. In doing this it
performs a service of recognized and undoubted social value.
There is another kind of risk-taking the social utility of which is
not at first sight so clear. Among the chances of productive
enterprise are those due to the rise and fall in the prices of the raw
materials, the labor, and the finished product between the time when
the process of production is begun and the time when it is completed.
Every farmer, every manufacturer, every student even who invests
capital in his own education, is to some extent a speculator. Along
certain lines he can protect himself by insurance, but that is not
possible in all. Is there no way, then, by which he can guard himself
against price fluctuations and assure himself of the legitimate gains
of his business? This, it may be answered, is the function of the
speculator in modern business, and in performing this service he is
benefiting society in much the same way that the insurance company
does. We must, however, clearly distinguish between legitimate and
illegitimate speculation; we are discussing only the former.
One way in which the speculative risk attaching to price fluctuations
is reduced for the manufacturer and assumed by the speculator is by
the establishment of a continuous open market, as the stock and 53
produce exchanges. If a miller, for instance, engages to deliver flour
a year hence and expects to begin milling in six months, he must know
at what price he can buy his wheat when he needs it, or his
anticipated gain may be turned into a loss by an unexpected rise in
the price of wheat. He is able, however, to buy a “future” in wheat on
the produce exchange from some broker who makes a specialty of this
business. He buys his needed wheat now for delivery six months hence,
and on the basis of this price is able to accept an order for his
flour a year from now, allowing himself a fair profit as a miller but
wholly eliminating the speculative risk of price fluctuations. Or a
building contractor, before making an estimate of the cost of erecting
a structure, will secure options at definite prices from dealers on
the materials he will require. So, too, in the iron and steel business
it is customary for manufacturers to contract in advance for materials
at the same time that they accept orders for the delivery of the
finished products. In all these cases the business of dealing in
futures is assumed by a particular class, who have developed a special
skill and ability in forecasting price variations, and who can do so
very accurately. It is not a matter of luck or chance, but the result
of wide knowledge and careful study. “To foretell the price of wheat
one must know the rainfall in India, the condition of the crop in
Argentina, must be in touch as nearly as possible with every unit of
supply that will come into the market.” Sometimes the speculators make
mistakes, but they are certainly less apt to do so than men who are
without their special talent and training.
The social value of this service lies in the equalization of demand
and supply between the present and future that is thereby effected.
Let us take as an illustration the case of the miller cited above. If
at the time he accepts the order for flour the price of wheat is high,
he will be inclined to charge a high price. But the wheat broker,
foreseeing that there is going to be an abundant crop six months 54
hence, engages to sell him his wheat for future delivery at a low
price, and he is thereby enabled to sell his flour at a lower price.
At the same time the price of the wheat on hand at the present time,
instead of being held and sold at famine prices, is consumed for
present needs at moderate prices. The operations of the wheat brokers
in such a case have a very steadying influence on prices, preventing
the oscillation between very high prices in times of scarcity and very
low prices in times of glut. It must be admitted that dealings in
futures are highly speculative; “but it must be remembered that it is
not merely the dealings in futures, but the future itself, that is
uncertain. If such dealings can be confined to the men most competent
to make accurate predictions, their tendency will clearly be to lessen
the uncertainties of business.”[8] But closely connected with
legitimate speculation or risk-taking by a specialized and trained
class, there is, as our stock and produce exchanges are actually
conducted, a large amount of illegitimate speculation, and to this we
may now turn for a brief consideration.
The facilities offered by the open markets on the exchanges and the
practice of dealing in futures are taken advantage of by many who,
without any special training or opportunities of knowing the market,
simply bet on the price movements. Brokers are willing to buy and sell
produce or stocks for their customers if the latter will put up with
them a margin of about 10 per cent to protect them from loss. It is
therefore possible for a person with little capital and no knowledge
to speculate on a margin, buying what he does not want and selling
what he does not own. In practice it is impossible to distinguish
between those dealings in which actual delivery is intended
(legitimate speculation) and those in which no such delivery is
contemplated (gambling), and consequently most efforts to regulate 55
transactions on the exchanges have failed to accomplish their purpose.
The purification of their methods would seem to lie with the members
of such exchanges themselves. The contention has often been made that
these fictitious transactions in such commodities as wheat or corn or
cotton create an artificial reduction in prices, since the
professional gambler usually sells short or “bears” the market, and
that this injuriously affects the farmer. This is manifestly
untenable, since every fictitious sale must be balanced by a
fictitious purchase. What actually takes place is simply a bet between
the two parties to such a transaction on the actual course of prices
and of itself does not affect prices, except in the unusual case of a
“corner.” There is, however, great possibility of evil in the presence
of a crowd of uninformed speculators, for they can greatly increase
the power of an unscrupulous operator who can persuade them to follow
his lead. Their presence, too, increases the temptation to such a man
to rig the market. Under present conditions the abuses of speculation
are more in evidence than the economic advantages. How to confine
speculation to the small group of risk-takers who have special
training and aptitude for it, and to prevent gambling on the stock and
produce exchanges is one of the economic problems of the day.
One of the most striking phenomena of modern industry is the frequent
and violent convulsions of business known as crises. They are
characteristic of all commercially advanced countries and are
generally most marked in those countries which are most advanced. They
are a product of modern methods of capitalistic production and are
essentially a phenomenon of the nineteenth century. A crisis in its
last analysis is the result of a lack of adjustment between production
and consumption, due primarily to mistakes in production. It is
significant that crises usually occur in periods of business
prosperity when credit is easy, prices high, and employment general. 56
Such a period of business prosperity and rising credit may have been
begun by a series of good harvests. The demand for manufactured
commodities increases, prices rise, manufacturers enlarge their
factories or engage in new enterprises, wages and profits go up. Many
speculators, seeing the rise, and thinking it will continue, borrow
money to buy goods with the expectation of selling again at a profit.
Credit operations are expanded to a dangerous extent, and when at last
a shock to confidence occurs the house of cards collapses and a
painful liquidation and readjustment of industry ensues. The state of
trade, in the words of Lord Overstone, “revolves apparently in an
established cycle. First we find it in a state of quiescence--next
improvement, growing confidence, prosperity, excitement, over-trading,
convulsion, pressure, stagnation, distress, ending again in
quiescence.”
The immediate occasion of a crisis is always a shock to credit or
confidence. Such a shock, begun perhaps by the failure of a bank or
merchant, creates a demand for ready money. No one is sure that his
neighbor will remain solvent. Everyone accordingly tries to secure
himself against loss by enlarging his cash reserve and thus lessens
the supply for others. Now modern industry is carried on by means of
credit. There is at no one time enough money in the country to meet
all obligations expressed in terms of money. Considerably over
three-fourths of the larger commercial transactions in the United
States are carried on by means of credit. If everyone tries at the
same time to get actual cash, there is simply not enough money in the
country to go around. This increase of demand and diminution in the
supply of money forces up the interest rate on short-time loans.
Money--actual cash--is needed by many people to meet immediate
engagements and they are willing to pay almost any price for it. In
the last panic the rates for call money went up to over 100 per cent 57
and in many cities in the United States clearing-house certificates
and other substitutes for money were issued for use in ordinary retail
trade. But even at high rates money can often not be borrowed. Many
merchants and manufacturers are compelled to sell their goods at a
sacrifice in order to obtain it. Vast quantities of goods and
securities are thrown on the market just when investors and consumers
feel least able to purchase. The result is a fall in prices. Such a
fall in prices lowers profits. Enterprises have been started and
engagements made on the supposition that prices would continue at the
old high level. When they fall it is impossible to pay interest out of
current earnings. Foreclosures and readjustments take place. There is
a general liquidation and reorganization of industry. When interest
contracts have been adjusted, then the effect on wages begins to be
felt. As long as a manufacturer is struggling to maintain his credit
he will keep his factory going, but when he has failed and perhaps
been foreclosed, then the factory stops. Men are thrown out of work,
and wages--the price of labor--fall. Labor troubles usually mark the
end of such a period of readjustment.
This stage marks the end of the crisis and the beginning of a period
of depression or “hard times,” which continues for a longer or shorter
period. The panic of 1893 was followed by a long-continued depression
which lasted until 1897, a period which was marked by low prices and
slack work. In 1898 began a revival of business and an era of marked
prosperity set in which continued for almost ten years, interrupted
only slightly by a “Wall Street panic” in 1903. In October, 1907, a
severe crisis occurred, recovery from which, however, has been
remarkably rapid. The periodicity which has attended crises in the
past is so marked--occurring as they have at intervals of about ten
years--that many writers consider them inevitable. As the easiest way
to answer this question we may take up three main theories as to the 58
causes of crises.
A much quoted, but now generally discredited, theory is that of W. S.
Jevons, a noted English economist, who ascribed crises to sun-spots.
Every ten years and a fraction there occur outbursts of electrical and
heat energy on the sun, which we call sun-spots. These result in
increased heat waves, which affect the crops on the earth, causing
enlarged harvests in Europe and the United States and drought and
famine in India and the tropics. The large harvests and good prices
start a wave of prosperity and speculation, which culminates
inevitably in a panic and depression, until a recurrence of the heat
phenomenon starts the cycle again. The theory states some undoubted
facts, but no causal connection between sun-spots and crises can be
traced, as the latter are too irregular and the two do not always
coincide. Were this theory true crises would be beyond human control.
A second theory, or group of theories, are those which attribute
crises to over-production. Under modern conditions of industry a small
group of men direct industry and determine what shall be produced.
They try to estimate future demand and to adjust production to
consumption, but they often make mistakes. They divert capital into
unproductive industries, they produce the wrong things and create a
comparative glut in certain lines, and when they cannot sell their
goods at a profitable price they fail and precipitate a crisis.
Industry must then be reorganized and frequently control be put in the
hands of other men. A variation has been given this theory by the
socialists, under the leadership of Rodbertus, who insist that the
reason that there is over-production is because of the institution of
private property. Since the capitalists own all the tools of
production they pay the laborers only starvation wages. The latter
cannot possibly buy all that is produced and commodities consequently
heap up in the warehouses until they are thrown upon the market to be
sold at any price. Then a panic occurs and a readjustment of production. 59
The last of these theories regards a crisis as essentially due to a
failure of credit. It is seen that a large part of modern industry is
carried on by borrowed capital, by roundabout processes and for a
distant market and not upon order. That is, the success of a business
depends upon its ability to sell its goods when produced. Now the
aggregate volume of transactions that can be carried on in a year, so
runs the theory, depends upon the efficiency of the credit system;
that is, in general, upon the freedom with which banks are willing to
loan money to people who engage to repay it in the future out of their
ventures. If for any reason the banks reduce this accommodation the
amount of business that can be transacted upon borrowed capital is
lessened. Either some transactions must stop or prices must fall.
Either of these events causes commercial disaster. The contraction of
credit makes it impossible to get the goods into the right hands, and
so we have the phenomena of over-production in a great many lines. As
exchange and transportation have developed and markets widened, crises
have become more universal. According to this theory, they are
inseparably connected with the use of credit and can be controlled
only by a more careful granting of credit by the banks to industrial
managers. Another phase of the credit theory is presented by those who
insist that the cause of crises is the rhythmic overestimation of the
profits to be secured out of certain lines of production, or their
over-capitalization. The new enterprises are financed by the banks on
the basis of this mistaken over-capitalization, their organizers
engage to pay rates of interest which they cannot earn, and the crash
inevitably follows. This is often called the over-capitalization
theory, and is essentially psychological in its character.
There is no doubt as to the truth contained in this last theory. It
helps to explain the rhythmic periodicity of crises. After every 60
period of business depression confidence revives and hope is renewed;
overestimation of the success of new ventures is inevitable. Then
follows a mistaken investment of capital in certain lines of
production, as in railroads in 1884, and a relative over-production at
profitable prices of certain commodities. The true explanation seems
to be found in a combination of the over-production and
over-capitalization theories.
The practical problem that presents itself in this connection is the
question as to whether it is possible to prevent the recurrence of
crises. In view of the explanation just given it would seem that they
must be regarded as unpreventable as long as industry is carried on
under the competitive capitalistic system of production and the modern
credit system. Moreover, crops differ in amount from year to year and
probably always will. Human production and human genius are unequal.
Crises may be regarded as the price a progressive society pays for its
advance, and they may be expected to recur pretty regularly at
periodic intervals. Their disastrous effects may, however, be greatly
lessened by wise currency legislation, by greater care in granting
credit, and by greater wisdom in the direction of individual effort.