fact that business conditions undergo alternate periods of prosperity
and depression extending in clearly defined cycles of substantially
uniform length. By tracing the usual course of interest rates and of
business conditions throughout one of these cycles, a general idea can
be formed of the way in which the joint influences operate to produce
price movements. To what extent the course of interest rates is a cause
as well as a result of changing business conditions, we shall not
attempt here to estimate, but will be content to note carefully the
general course which rates for money pursue throughout the cycles.
Immediately after a financial crisis, which usually closes an era of
great business prosperity, money rates become abnormally easy. Within a
few months from the climax of the crisis, money accumulates in enormous
volume in financial centers. This is caused by the great diminution of
business activity which renders unnecessary a large part of the
circulating medium that was formerly required to transact the greater
volume of business. To the extent to which this accumulation of money
merely reflects a redundancy of currency as distinguished from real
liquid capital, it can have little effect in encouraging the resumption
of business activity. As time passes, however, and economies in
operation commence to make themselves manifest, and especially as waste
and extravagance are curtailed, the country as a whole commences to
accumulate real liquid capital; that is to say, its total production
leaves a surplus over the amount of consumption. In the state of
business feeling which has been pictured, the undertaking of new
business ventures or additions to existing properties would not be
approved, so that the surplus wealth created finds its way into bank
deposits as liquid capital. The competitive attempt to loan this capital
at a time when borrowers are few produces merely nominal interest rates.
This continues for some time. It is only gradually as confidence returns
and as the spirit of initiative begins to reassert itself that some part
of the liquid capital created each year is diverted into fixt forms.
Here and there some enterprising group of men will develop a mine, lay a
new piece of railway, or make some addition to an existing undertaking.
For some length of time, however, the liquid capital of the country not
only remains unimpaired, but is continually increasing. After a time a
change comes. The annual surplus of production, tho larger than before,
is only sufficient to provide for the new undertakings which the growing
optimism demands. Interest rates rise moderately in response to the
added demand for capital. A few years further along, as business
activity increases and success appears plainly to wait upon new
ventures, the demand for new capital with which to develop increased
facilities and new enterprises exceeds the annual supply of wealth
created. Prosperity having increased, another factor commences to assert
itself. The spirit of economy and thrift which had prevailed throughout
the years of depression gives place to extravagance, the demand for
luxuries, and other unproductive forms of expenditure. While the total
production is much greater than in the lean years, the margin of
production is not proportionately as great, and this amount is
insufficient to meet the demands upon it. The supplies of liquid capital
stored up during the years of depression are resorted to, and they serve
to provide the new capital for a few additional years. Interest rates at
once reflect the encroachment upon stored-up capital, and their rise
gives the first real warning of the country's true position. The
optimistic business men do not heed the warning. After exhausting all
the real capital available in the country, they proceed to borrow
extensively from foreigners or from government banks--in this country
from the national government through bank deposits. Every step which can
be taken to induce foreigners to part with their capital is resorted to.
If foreigners will not buy long-term bonds, short-term notes are
created. If the foreigners refuse these, they are asked to make loans
secured by the new bonds and notes. The rates of interest offered are so
attractive that considerable sums are usually obtained, and the pressure
of business activity continues further. Finally the day of reckoning
arrives when some incident, usually unimportant in itself, first
suggests to the lenders of money that their debtors whom they know to be
overextended may not be able to pay their loans. The attempt to collect
their loans produces a financial crisis which brings to an end the
period of prosperity.
The foregoing is a description of the more important stages through
which business conditions pass from crisis to crisis. Different cycles
vary in particular details, but all agree in essential outlines.
Sometimes special influences are at work which operate to shorten or
prolong the cycle. The approach of a crisis will be retarded by
inflation of the currency, for the excess finds its way into bank vaults
and increases the volume of loanable credit. The effect of such
inflation, however, is wholly disastrous, because the addition to the
supply of capital is fictitious, not real, and only defers the day of
reckoning for a greater catastrophe. On the other hand, the approach of
a crisis can be greatly hastened by wars, conflagrations, and other
agencies which destroy capital, and by attacks upon capital and the
conduct of corporate business, for such attacks tend to render capital
timid and produce the same effect as a violent curtailment of the
supply. These are only some of the many influences which might become
operative, but they serve to show the necessity for careful
consideration of all the factors at work if a true conception of the
condition and tendencies of business is to be formed.
From the general account given above of the successive phases of a
credit cycle, it is possible to summarize the course of interest rates
and the course of business conditions. Money rates become suddenly easy
after a crisis, remain low or grow easier for a period of several years,
and then rise continuously until the next crisis, advancing with great
rapidity toward the close of the cycle. Business conditions remain poor
or grow worse a few years after a crisis. Liquidation is taking place,
prices are going down, and the uncertainty of the outlook causes
diminished activity. Thereafter, however, conditions improve and
activity increases with fair uniformity until it reaches the high
tension of the period immediately preceding the crisis. The course of
interest rates and the course of business conditions may both be
deflected by the operation of special influences, but the general
tendencies are substantially as outlined. The result of the operation of
these joint factors may be traced in the market movements of any class
of security desired. For the sake of simplicity, let us consider their
effect in producing the market swings of the highest grade of investment
issues and of the lowest grade, those which are affected only by money
rates and those which are affected almost wholly by business
conditions.
Emerging from the strain of the crisis at their lowest point, high-grade
bonds, such as the best municipal and railroad issues, advance rapidly
as interest rates decline, continuing their advancing tendency
throughout the period of business depression which follows upon the
heels of the crisis. As business conditions improve, their position,
while perfectly secure before, is further strengthened and an added
stimulus is given to their rise. About the middle of the cycle when the
business outlook is very promising, and before interest rates have
sustained any material advance, the prices of high-grade bonds are
usually at their highest point. From that time forward they commence to
decline, in spite of the increasing prosperity of the country, under the
influence of rising money rates. They make their lowest prices in the
midst of the crisis, when the strain upon capital is greatest and the
outlook for business most unpromising.
The lowest grade of bonds, on the other hand (whose margin of security
is least), do not commence to recover materially in price, in spite of
the influence of low money rates during the hard times which follow the
crisis, the influence of reduced earnings and the fear of default of
interest holding them in check. As the outlook becomes brighter, they
advance rapidly and continue to improve in price so long as they yield
more than current money rates. At some point, difficult to determine in
advance but usually well along toward the end of the cycle, they reach
their high point and thereafter decline under the influence of the
growing stringency in money.
Between these two extremes, every class of security is to be found. The
better ones will tend to resemble, in their market movements, the course
pursued by the choicest bonds; the poorer ones will approximate the
lowest class. In every case, however, unless special influences operate
to produce variations, the market swing of a given security should be
easily conjectured by an investor who gives careful attention to the
relative weight which is likely to attach to each determining influence.
* * * * *
Transcriber's Note: Spelling remains as in the original except
"qualities to be emphasied; for investors" has been changed to
"emphasized".
End of Project Gutenberg's How to Invest Money, by George Garr Henry