Wherever large-scale industrialization appeared, the economic system was subjected to alternating periods of prosperity and depression, often marked by a "crisis" in finance and business confidence. These breakdowns occurred with varying degrees of severity but with an apparent regularity that
*It should be noted, however, that some economists never accepted the theory of marginal productivity. This dissident group included Alfred Marshall, the dominant figure in English economics from 1890 to the post-World War I period.
required explanation. During the nineteenth century, financial crises followed by depressed economic conditions occurred in England in 1815, 1825, 1836, 1847,1857,1866,1873,1882,1890, and 1900. In the United States crises were somewhat less frequent, perhaps because of the presence of an extensive land frontier, but they were still numerous, occurring in 1819,1837,1854, 1857, 1873, 1883, and 1893. Furthermore, the world economy experienced three "great depressions" during the "hungry forties," the 1870s, and the 1890s.
At first the problem was ignored. Both the classical economists of the first half of the century and the neoclassical group that appeared after 1870 accepted the general propositions of Say's Law of Markets, according to which there should be no periodic economic breakdowns and the economy should continue to operate at uninterrupted high levels of output and employment. Those few who did investigate business cycles looked for causes outside the system of production and distribution, for Say's Law taught that demand was created by production and that, in the aggregate, the two could never get out of phase with one another.
Beginning in the 1860s British and French statisticians, rather than economists, first verified the periodic and cyclical nature of economic fluctuations. They identified several cycles of about ten years' duration and speculated on possible causes. Stanley Jevons in England was one of the few economists who gave much attention to the problem, and he attributed the causes of "great irregular fluctuations" to variations in agriculture, excessive investment or speculation, wars and political disturbances, or "other fortuitous occurrences which we cannot calculate upon, or allow for." Later Jevons developed a theory even more favorable to the adherents of Say's Law and the existing scheme of things. After finding a statistical correlation between cycles of sunspots and business fluctuations, he wrote in 1884:
It seems probable that commercial crises are connected with a periodic variation of weather affecting all parts of the earth, and probably arising from increased waves of heat received from the sun at average intervals of ten years and a fraction.
But business cycles were creating problems for government, too, and hardheaded administrators responsible for policy needed facts. Government men sat down to analyze the data. In 1886 Carroll Wright, in his first annual report as United States commissioner of labor, identified business investment as the most important fluctuating element in the economy. Natural events, wars, and speculation were not the cause of crises: the culprit was overinvestment in capital equipment. Bad times came when opportunities for investment were inadequate. This emphasis on the process of investment was reiterated a few years later by Sir Hubert Llewellyn Smith, Wright's English counterpart as commissioner of labour in the Board of Trade, who reported to Parliament in 1895 that economic instability was concentrated in a few industries, such as machinery and other metals-producing industries,
shipbuilding, construction, and mining, all of which were subject to "violent oscillation" in investment. Other sectors of the economy were relatively stable, and fluctuations there reflected the larger changes taking place in unstable industries.
These investigations by government agencies did not have much effect on economists, however, who continued to pursue the clues given them by Say's Law. In its best and most complete formulation that law utilized the rate of interest as the automatic stabilizer of the economy, the factor that ensured that savings would be directed into investment and prevent any break in the even flow of spending. But since breaks were obviously occurring, and since the rate of interest was part of the monetary system, it was logical to look to that sector of the economy for the causes of difficulty: There could be problems in the monetary system even though production and distribution were sound.
By the last decade of the nineteenth century, many economists began to agree that business cycles were caused by unwarranted expansion of the money supply. Easy credit would bring interest rates down and thereby stimulate excessive investment and speculation. Once the economy had overexpanded a crisis was inevitable, since the normal operation of the system could not support the unnecessary production capacity and credit created during the wave of optimism. After a crisis began, the economy would simply have to suffer until the high prices and unwise expansion were brought back to normal.
The preventive for this unfortunate sequence of events was to manage the monetary system properly. Limiting the expansion of credit to the legitimate needs of business through effective action by the central bank could prevent the process from starting or could stop it while the ensuing readjustment period might still be short and shallow. Stability in the monetary and credit system could bring stability to the economy as a whole.
This theory was spelled out by the Englishman Walter Bagehot as early as 1873 in Lombard Street, a classic work on the money markets. It was taught at Harvard around the turn of the century by Oliver M. W. Sprague, one of whose students was the young Franklin D. Roosevelt (who learned the lesson well but was later critical enough to reject it as the basis of policy). It was the theoretical basis for the establishment of the Federal Reserve System in this country in 1914. President Herbert Hoover had this theory in mind when he said, shortly after the 1929 stock market crash, "The fundamental business of the country—that is, production and distribution— is sound." He didn't mention the monetary and credit system, which obviously was not sound and which he tried to strengthen by loans to banks and railroads (whose bonds were owned heavily by the large banks) and by trying to cut federal expenditures. But Hoover's policies pointed up the bias inherent in Say's Law of Markets and in the theory of business cycles it spawned. Production and distribution were not sound in 1929, although the theory denied that causes and remedies could be found and applied in those areas.