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The Liquidity of Short-Term Capital’

By Fritz MACHLUP.
(Vienna.)

I

THE object of this paper is to discuss the question, Can short-
term capital remain liquid? The bottom of a great depression
is, I feel, a particularly suitable time to investigate this question
and to criticise accepted doctrine. In times of prosperity, prac-
tical business men would scoff at the thesis, which I wish to
put before you, that short-term capital is never really liquid;
but in times of depression the majority of savers and owners
of capital, and also the majority of bankers, are inclined to admit
that there may be ‘‘ something in it.”

In a depression, savers discover from bitter experience that
their short-term loans ate no longer liquid but frozen for at
any rate the immediate future, and they therefore become too
nervous to invest fresh savings in productive processes, and
what Mr. Keynes calls ‘‘ bearishness ’’ is increased; that is,
there is a growing tendency to hoard money or to deposit it with
the banks for a short time.

Such a decrease in the supply of capital as is caused by these
tendencies has greatly increased the immediate difficulties of
the present economic position, and the general scramble to
liquidate credits and investments has led to the actual financial
and monetary crisis from which we are suffering. It is the
object of this paper to deny every existing theory of liquidity ;
but since, as is well known, economic theory has little effect

on economic actions, I need not be afraid that this denial will
~ strengthen the general liquidation mania !

Before expounding a general thesis, I must make clear certain
points of terminology. By liquid, I do not mean the same thing
as Mr. Keynes, who is inclined to consider all goods in process
as well as finished goods—whether consumption goods or
producers’ goods—as liquid, whether they can be sold or not.

* A paper read before the London Economic Club, July 17th, 1932.
271


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272 ECONOMICA [AucusT

Indeed, Mr. Keynes has defined as liquid capital just that which,
according to a German-Hungarian critic," is the least liquid
part of working capital ; that is, surplus stocks or excess stocks.
Now, according to the most important business usage, ‘liquid ”’
means ‘‘ immediately convertible into money.”” Mr. Keynes’
usage, therefore, would appear to conflict with the maxim that
it is undesirable to use terms in a sense different from the sense
in which they are used in everyday life.

But the business usage is by no means free from ambiguity.
For there are, in everyday life, many forms of capital which
are liquid—in this sense—at one time and not at another. This
would appear to be a contradiction in terms. We must, there-
fore, examine at some length this concept of private liquidity.

It is easy to see that the same reasons which make it
impossible to regard fixed capital—buildings, machines and so
on—as being liquid, are applicable to the whole problem : the
owner of a machine can liquidate this capital only when another
‘investor invests the same amount. The liquidity of the first
involves the illiquidity of the second. Individual liquidity is,
therefore, not the same as the liquidity of the whole system.

This is valid not only for fixed capital but also for working
capital. From the point of view of the machine maker, the
machine is obviously part of his working capital, but to the buyer
it is part of fixed capital. The total liquidity of capital is inde-
pendent of the ownership of investment goods, since the capital
of one man can never be regarded as liquid if it is so only when
another man is investing and thus tying up a corresponding
amount. Goods are liquid in this sense only when they can
be transferred to -actual and immediate consumption. ‘This
means that they must be not only ready for consumption but
also saleable.

II |
There is only one use for capital; that is, to produce. This
concept of ‘‘ production >’ embraces all processes which are
necessary for the completion of goods and making them ready
for immediate consumption ; this naturally includes the necessary
transport through time and space; that is, all transactions of
commerce and speculation.
Short-term capital means that the command over purchasing
power can be used for production in the above sense only for

1 Julius Neubauer, in Schmollers Jahrbuch, 1932.


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1932] THE LIQUIDITY OF SHORT-TERM CAPITAL 273

a short time. - This implies that the journey from money
through production and back again to money must be very
short and quick. At present, we are not concerned with whether
‘this short-term capital is due to temporary saving or a temporary
additional bank credit.

Discussions of the question of how short-term capital can

be invested so that it is reconvertible into money after a short
period, are already very old, and most. theorists and practical
men cling to the concept of circulating capital as consisting
of goods in process and raw materials.
, But this concept of the liquidity of all materials contains
a paradox in that many of these raw materials are destined
to be transformed into fixed production goods. For example,
iron and coal—which are at first said to be liquid—may, after
passing through the various stages of production, become fixed
capital in the form of machines, The ability of a producer in
a higher stage to set free his working capital depends, therefore,
on the willingness and ability of an entrepreneur to invest
capital for many years. ‘There is obviously no sense in speaking
of the liquidity of the working capital from the point of view
of the whole system in such a case.

But even the limitation of the characteristic of liquidity to
capital invested in goods which go directly through the whole
productive process without becoming fixed, is not justifiable.
Even if the invested money returns after every period of produc-
tion to the individual entrepreneur, this is not the same as
saying how long the total period of circulation of capital is—
the period needed for the whole course through the stages of
production to the final marketable consumption goods.

If we attempt still further to limit the applicability of the
the term ‘‘liquidity ”’ to the use of capital in the stages imme-
diately before the final stage of production of consumption
goods, then we must make still further qualifications. Expan-
sion of production in the lowest stages may involve expansion
in the higher stages, and this process may not, in a complicated
productive system, be finished in time. But since short-term
capital can be used only in the shortest possible productions,
investment in consumption industries is suitable only in so
far as this does not increase the demand for the products of
the higher stages.

If we are convinced, by these considerations, that most kinds
of investment are not possible without long-term capital but
that we have found one kind of occupation suitable to the invest-


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274 - ECONOMICA . | : [Aucust

ment of short-term capital, we shall be disappointed by the
conclusion that working capital is not really liquid even in this
case—save at the expense of reducing the volume of production.
For,. if we want to maintain the volume of production and
output, we cannot liquidate any part of the working capital.
I hope it is clear by now that the entrepreneur must reinvest
that money which he receives from the sale of his output if
he wishes to repeat the same process of production.

Since working capital, according to my definition, is that
part of invested capital which may be set free by the stoppage
of production, it cannot easily be distinguished from fixed
capital, in so far as the maintenance of a given volume of
production is assumed. When working capital circulates, it
is liquid not for repayment, but only for reinvestment. Thus
the final liquidation of working capital is possible only at the
expense of diminishing or stopping the work of production.

‘Let us, at this point, restate the cases in which short-term
capital can neither remain liquid nor become liquid after a short
period. ‘These are when i it is invested either :

(1) in fixed capital ;

(2) in working capital which is destined to become fixed
capital ;

(3) in working capital which is destined to go through a long
process of production;

(4) in working capital in a lower stage of production when
this involves an increase in production in the higher
stages;

(5) in working capital in industries in which the output
needs to be perpetually maintained.

On the other hand, it seems that we have discovered so far
that investment of short-term capital in such a way that it can
quickly be liquidated, is possible only when it is used for such
temporarily increased production of consumers’ goods as does
not increase the demand for the products of the higher stages—
especially of fixed capital. There is a general belief in the
existence of such ¢‘ self-liquidating ’’ investments. Let me
illustrate this kind of investment by means of an example taken
from Professor Polak’s Grundziige der Finanzierung mit Riick-
sicht auf die Kreditdauer.?

‘“ The current supply of clothes requires that there exists

2 Berlin-Vienna, 1926. P. 155.


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1032] THE LIQUIDITY OF SHORT-TERM CAPITAL 275

at any momert a stock of raw cotton in the hands of traders,
a stock of cotton, raw and in process, and of yarn in the
spinning mills, a stock of yarn, semi-manufactured materials
and of cloth in the weaving factories, and a ‘stock of cloth
in the hands of retailers. Capital is invested by the traders
in the stock of raw cotton. This capital has been advanced
at short-term by a bank which obtained it from the depositors.
Now when the depositors withdraw their money in order to
buy cloth, the retailer finds his stock decreasing and orders
new cloth from the weavers. The latter order new yarn from
the spinners and the spinners have to replenish their stocks
of raw cotton. In this way, the demand exercised by the
former savers causes the decrease of the traders’ stocks of
raw cotton, in which their capital has been invested.”

Our problem is to discover the degree of probability of the
existence of such forms of investment for increased short-term
capital. To cautious bankers, who—in England, if not in
Central Europe—are supposed only to make advances to finance
the sale of goods, this inquiry must seem idle. They would
say : ‘‘ It is quite ridiculous of Mr. Machlup to try to discover
theoretically whether our advances are used for self-liquidating
investments. We only make advances for such purposes.’”’ Let
me first defend myself against such objections.

Perhaps you know the saying: ‘ You may think that you
give a man bread and housing, but in fact you make his money
available to buy beer.”” You may change it to: ‘‘ You think
you give the borrower an advance against saleable goods, but
in fact you make it possible for him to buy new machines.”
The entrepreneur who receives fresh advances for working
capital, in fact has part of his own working capital set free—
which was previously needed for circulating capital ; so that
he can now invest his own funds in fixed capital. Thus, the
actual concrete and visible use of a fresh credit does not
correspond to the intended use.

A banker once told me that he could avoid such things by
refusing credit to any entrepreneur who wished to invest in-
fixed capital; he could refuse even the harmless documentary
credit. Apart from the fact that I do not believe that bankers
behave in such a way, this would not alter the problem in the
economic system as a whole, for the new investment which is
made possible by the fresh short-term capital may not be in
‘the borrower’s own business. The new credit may possibly set


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276 ECONOMICA [AUGUST

free old credits which are now repaid and thus free for invest-
ment in other places; it may place the entrepreneur in such
a position that he needs less credit from his suppliers and will,
by that means, make the latter able to invest themselves or to
extend credits to their other customers who can, in turn, invest;
or it may, finally, make it possible for our entrepreneur to give
more credits to his own customers, and thus enable investments
in their business or in that of their business friends to take
place.

So, you see, in practice one can never tell who is going to
use the credit, and for what purpose it will be used. But in
theory one can tell much more and one can also see deeper.
One can inquire into the different possibilities and can under-
stand which kinds of investment are probable and which not :
let us try to make this inquiry.

III

We must assume that the new short-term credit is used for
a purpose which was not realised before. This is quite obvious,
since every additional supply of capital disposition means that
the total demand for capital can be satisfied to a greater extent
than before and, therefore, that the °‘ unsatisfied fringe ’’ of
borrowers, who until now were excluded by competition from
obtaining a share of the supply of capital, will now obtain some.
We must, therefore, examine the needs of these new marginal
borrowers.

The question turns on the distinction between the class of
borrowers who were previously satisfied and the class who were
previously excluded from the market, and what are the needs
which can now be satisfied.

A simple logical consideration, which has been adduced by
Professor Strigl, concludes as follows: The fresh borrowers
employ the fresh capital—either for a new enterprise or for
the expansion of an already existing one—by demanding means
of production, partly original factors of production, partly inter-
mediate goods, This increased demand will raise the price of
production goods, Therefore the borrowers who are in the best
position to compete are those who are less affected by the
increased cost of intermediate. goods than by the lowering of
the rate of interest. This is not the case with investment in
raw materials and goods in process, but it is the case with invest-
ments in fixed capital since in calculating the prospects of such


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1932] THE LIQUIDITY OF SHORT-TERM CAPITAL 277

investments the interest rate is of much greater importance than
the price of the goods used.

Which competitors for capital were certainly satisfied before
this? That class of entrepreneur, in whose calculation of
prospective yields the factor of interest has no great weight;
that is, those who used little fixed capital or who did not
produce durable goods, If, up till now, the price of capital
disposition, i.e. the rate of interest, has excluded some uses
of capital, then we may be sure that they were uses for which
the rate of interest was an important factor ; that is, the employ-

ment of fixed capital.

In my last book,® I drew a further conclusion which comes
to the same thing but which was criticised by Dr, Haberler—
to whom I will refer later on, I argued as follows : The question
is whether it is possible to expand the production of goods in
‘process and of finished consumers’ goods, without any increase
“of fixed capital, That would be technically possible by using
the capacity of the existing plant more fully. But can this also
be possible in the economic sense ; that i is, can that be profitable?
I maintained that, since such increase in production would cause
‘a decrease in overhead charges, due to the more complete use
of fixed capital, the fact that the increase did not take place
before is not to be explained by lack of capital but only by
other factors—such as the steep rise in the prime cost curve.
Cheaper credit can, therefore, never involve the increase of
such a production.

I concluded, therefore, that the investment of fresh capital

for an increase of production and output which might be
technically possible without expanding fixed capital, is
economically impossible. But we have already decided, as a
result of our earlier discussion, that the only suitable use for
short-term capital would be for a temporarily increased produc-
tion of consumption goods, which do not need any production
‘in the higher stages. Now we have seen further that a larger
supply of capital will never lead to such investments. We must
conclude, therefore, that the short-term use of capital is
theoretically impossible.

But we must not push our conclusions too far, or our thesis
will seem very improbable to people who know from statistics
that large new investments in so-called working capital are
continually taking place. There is no contradiction between
this fact and our own theory, for alterations in the number and

3 Borsenkredit, Industriekredit und Kapitalbildyng. Vienna. 1931.


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278 ECONOMICA : [AUGUST

“age-distribution of the population, alterations in technical
knowledge, in taste, in seasonal or trend movements of the
whole system must alter the volume of the demand for goods
in process and for finished goods. Besides these factors, an
‘increased investment in such goods must always be the conse-
quence of increased investments in fixed capital, partly because
the production of the new durable goods needs an increased
working capital to be transformed into plant, and partly because
"the new fixed capital goods demand working capital as comple-
mentary goods.

Nobody, I think, will regard these factors as contradicting
my thesis since, in the last case, everybody will understand
that the increased working capital is even less an investment
which can be easily liquidated, and in the other cases the
increased demand for working capital is due to structural altera-
tions in the system and, therefore, equivalent to a demand for
perpetual use and not for temporary use. But only a temporary
use would make a quick liquidation possible. There remains
only seasonal variations in the demand for capital. This is a
special problem about which I made some suggestions in my
book. At this point I will only state my opinion that seasonal
fluctuations in stocks do not correspond to seasonal fluctuations
in the true demand for capital.

Iv

The objections made by Dr. Haberler to my thesis that the
form of the cost curve would not permit an increased investment
in working capital without increased investments in fixed
capital, are to a certain extent justified. Dr. Haberler argues that
the assumption of decreasing overhead costs is undoubtedly
correct but irrelevant to the actual problem. The certainty
that total marginal costs will increase was a reason for not
investing more working capital before. But if the rate of
interest is reduced, the total cost curve falls and some further
doses of working capital can be invested, the return on which
will, indeed, be lower than the former rate of interest, but will
equal the new, lowered, rate. Thus, if we do not assume a
discontinuous cost curve, the increased supply of capital disposi-
tion must also cause an increased investment in | working capital
in the said industries.

It may be useful to illustrate the change in the costs of
production by means of some concrete examples.


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1932] THE LIQUIDITY OF SHORT-TERM CAPITAL 279

Let C be the unit costs of production.
F the fixed overhead costs. |
P the prime costs (for wages and materials).
I the interest paid on the current working capital,
O the volume of output per year.

The costs of production are then:

Now, let us substitute reasonable figures. Let us assume that
the turnover of working capital is every four months—or three
times a year—and that the rate of interest is 5 per cent.

00,000
100,000 + 900,000 + (22229%° X 0°05)
C=
100,000
100,000 + 00,000 X I5,000

100,000 -

If you remember that the marginal unit cost of production must
increase with an increased volume of output, you will see that
the decreasing rate of overhead costs must be over-compensated
by increasing prime costs. With the increase of O from 100,000
to 110,000 pieces, P would, e.g., increase to 1,002,000.
Next, let us see the effect of a fall in the rate of interest from
5 per cent. to 4 per cent. Will the increase of output be
attractive now? We will calculate the costs at an output of
110,000 pieces :
ea Ts SETS VEE 1,002,000

100,000 + 1,002,000 + ( X 0°04)
C,= 110,000
100,000 + 1,002,000 + 13,360
110,000
1,115,360
ERIE Ta Er As 110,000

The whole diminution of unit costs is, therefore, from 10°15
to 10°14 or o'I per cent., while the interest rate has fallen
by 20 per cent.

The relatively small effect of the change in the costs of credit,
invested in working capital, on the total cost of production is


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280 ECONOMICA [AucusT

easily comprehended if you understand that we have there a
fraction of a fraction of a fraction. The volume of working
capital is only a ratio of the total annual prime costs, a ratio
which depends on the rate of turnover; naturally, the interest
on the working capital is only a percentage of that; and finally
a decrease in the rate of interest is only a fraction of the latter.
In our example, the rate of interest which was decreased by
20 per cent. involved a decrease in total costs of o'1 per cent.
An increase in the prime costs—in the cost of production goods
and of wages—of less than 1 per cent. would have more influence
on total capital costs than an alteration of 20 per cent. in the
cost of borrowed capital. And you will easily appreciate the
fact that the increase in credits and therefore the increase in
the demand for means of production, will cause this increase
in the cost of the working capital-goods which must exceed the
decrease in the cost of the working capital-disposition.
Nevertheless, although we have found that we cannot alter
the conclusions reached in my last book, I must concede to
Dr. Haberler that the formulation of the one argument was not
quite exact. The given formulation is suitable only for the
case in which the lower rate of interest would not affect the
old capital and credit, and would only concern fresh capital.
But, in the end, we can still conclude that, starting from an
equilibrium state, there can be no economically justified invest-
ment of capital disposition without increased fixed capital.
Many of the errors and misunderstandings in the theory of
interest and investment are caused by the habit of regarding
the rate of interest as only a factor of costs and of inquiring,
therefore, only into the changes in the cost curves of goods,
which must take place in consequence of a change in the rate
of interest. ‘This one-sidedness is shown with special clearness
in our problem. If you look only at the cost curves, you will
be deceived because the importance of the change in the cost
curve falls far short of the importance of changes in the demand
curve, caused by the increased command of capital. In the
first place, changes in the latter are shown most clearly in the
prices of investment goods upon which the altered rate of interest
acts to its full extent. While, in the former example, the
diminution in the rate of interest by 20 per cent. decreases
the supply price only by o°1 per cent., the demand price of
durable goods would rise by 20 per cent. |

¢ Cf. J. M. Keynes, Treatise on Money, Vol. I, p. 211.


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1932] THE LIQUIDITY OF SHORT-TERM CAPITAL 281

When we considered only the cost curves, we could ignore
the difference in the extent of the influence of the larger supply
of fresh capital-disposition on fixed capital goods on the one
hand, and on finished consumers’ goods on the other. This
great difference is due to the demand curves which are shifted
upwards for durable investment goods and downwards for con-
sumers’ goods—in so far as the fresh capital is supplied by
fresh savings. When the increased command of capital is due
to additional bank credits, the demand curve for fixed invest-
ments is equally shifted upwards, but it is only in a later and
secondary phase of the business cycle—caused by these bank
credits—that the demand curve for consumers’ goods is also
shifted upwards.

If we return again to the question of goods in process, we
find that owing to the increased supply of fresh capital the
demand for them by industries producing consumption goods
will decrease, and only the demand by industries producing
investment goods will increase. If, therefore, the demand for
goods in process increases, this will only be in order that they
may be transformed into fixed capital goods—a secondary effect
of the increased demand for long-term investments. In no case
is it possible for this increased working capital to become liquid
within a short period.®

\Y%

At this stage of my paper, it seems appropriate to note how
far my conceptions differ from those of the modern theory of
credit and capital. I will not speak about my theory of
seasonal fluctuations in the demand for capital—which I have
not discussed to-day-—because at present this position—which
is said by Professor Robbins in his very kind review of my
book to be revolutionary~—is still isolated. But my conception
that all fresh capital is used for long-term investments would
find some support in modern treatises.

My esteemed friend, Professor Hayek, will probably agree with
me. In his article against Messrs. Foster and Catchings,

5 Thegaddition of each new increment of capital will, of course, alter the
coniditi®fs of equilibrium and will give rise to certain disturbances in the
economic system as a whole; an attempt to withdraw this additional capital
will have a similar effect. For technical reasons, however, while the structure
of production may be modified with comparatively little friction when a
change has to be made to more roundabout (i.e. to more capitalistic) methods,

when the period of production has to be shortened as a result of liquidation
of capital, much more friction is. likely to be encounteted.


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282 ECONOMICA [AucUsT

published in 1929, he still deals with both types of investment
of additional capital; that is, with investment in durable and
in non-durable goods. He there states explicitly that by the
command of new capital the factors of production could be
transferred in ‘‘ kapitalintensive Betriebe ’’ without any incre-
ment of the existing fixed capital.’ In his new book on Prices
and Production,” he elucidates complex problems by schemes
which involve far-reaching simplifications and he is forced by
this reason to discuss omly long and short processes and to
disregard the problem of durable goods. But I am informed
that his present work is concerned with the theory of durable
goods.
. To discover from Mr. Keynes’ long and complicated work
what his exact meaning is, is not easy, but I believe that—on
this point-—I am in agreement with most parts of his Treatise.
Thus he states that the increased investment in working capital
will take place not in the primary but in the secondary phase
of the credit cycle.® And he declares that ‘‘ in equilibrium the
whole of current savings, apart from the normal growth of
working capital, is available for additions to fixed capital.”

But you will find parts of the Treatise in which a different
meaning is implied. ‘Thus he writes, ‘“ The increased invest-
ment may take the form of an increase of working capital,
corresponding to an increased total output due to an additional
production of consumption goods, being superimposed upon the
existing output.”’’® Mr. Keynes considers this type of Com-
modity Inflation as the most characteristic of a credit cycle. I
admit that the credit cycle tends to end up with this type of
inflation, which will bring about the collapse, but I cannot see
how it can begin with this kind. Mr. Keynes assumes ‘ that
the banks adopt a lending policy which allows the production
of consumption goods to increase.”’'’ But this is exactly the
case which I have shown to be impossible. One could perhaps
find out a system in which not the economic incentive—not
the prospect of profit—but public enterprise would cause produc-
tion to take place ; and public investments would start to increase
such production. But this case is irrelevant at this point.

But we have neglected Mr. Keynes’ conception of increased
employment by increased bank credits. We must therefore ask,
Can the increased volume of employment involve increased earn-

6 ¢«« Gibt es einen Widersinn des Sparens?’’ Zeitschrift fiir Nationaldko-
nomie, Band I, p. 415. Vienna. 1929.

7 London. 1931. 8 Op. cit., Vol. II, p. 102.  ? Op. cit., Vol. II, p. 112.

10 Op. cit., Vol. I, p. 281. (My italics.) 11 0p. cit., Vol. I, p. 30s.


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1932] THE LIQUIDITY OF SHORT-TERM CAPITAL 283

ings of the factors of production? And can this increased
income involve an increased demand for consumption goods?
Can investment in increased production of consumption goods
be possible after all?

There is, I believe, a certain contradiction in Mr. Keynes’
theory of re- employment. He is convinced that the unemployed
factors of production will return to work when their earnings
do not any longer exceed their marginal productivity. He holds
that instead of a reduction of nominal wages, the diminution
of the real earnings by the higher prices of consumers’ goods,
will have the same effect. In this connection, he makes some
very interesting remarks upon “ the redistribution of consump-
tion from the rest of the community to the newly employed. yr
““ Full employment of the factors of production requires a
redistribution, not a reduction of the aggregate of consump-
tion.”’'®* But no word of an immediate increase in total con-
sumption. Here Mr. Keynes is right, but it would seem obvious
that the first conception, which dealt with the increased con-
sumption, cannot be maintained.

Here we have found again that there is no way leading to
an investment in the production of consumption goods, and,
therefore, no way leading to a short-term investment of short-
term capital.

VI

My inquiry has, I think, exhausted all possibilities of short-
term investment, besides exhausting your patience. In spite
of sincere endeavours we have not been able to find out how to
invest capital in such a way that it can be reliquidated after a
short time. But how does this conclusion compare with the
fact that, in normal times, savers have not found their short-
time savings illiquid ?

The explanation is very simple. The short-term saving is
liquid in so far as a new saver takes the place of the liquidating
one. ‘The substitution of one saver or investor for another can
be expected in normal times. There is a continuous prolonga-
tion and turnover of the short-term loans and short-term invest-
ments. ‘The individual owners, creditors, and debtors change
but the volume of the capital is not reduced. If it is attempted
to liquidate more short-term capital than the amount of new
capital which is replaced, the creditors discover that their

12 0p, cit., Vol. II, pp. 124-5. 13 0p. cit., Vol. II, p. 126.


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284 ECONOMICA . [AvucusTt

capital is mot liquid, and can only be liquidated successively
according to the further supply of new capital or according to
the shrinkage of production.

We therefore reach the conclusion that private short-term
capital is, in the system as a whole, either—by a permanent
succession of savers—long-term capital, or—without this suc-
cession—not true capital at all. Which brings us back to a
proposition of Carl Menger, the famous Austrian economist,
published in 1871, which may therefore form my conclusion :

‘“ Quantities of goods which are at the disposal of economic
individuals only for such a short period that any productive
use is impossible, are therefore not true capital. »