Independent investment decisions were given a prominent part in all the previous theories but investment decisions, to a good extent, are based on the expectations and confidence of businessmen. John Stuart Mill (1848: Bk. III, Ch.13, 23, 24) and Alfred Marshall (1879) had already argued to some extent how confidence and speculation, coupled with "irrational extensions of credit" can disorganize production and create more or less goods than necessary.
In a sense, all the theories previously discussed have a psychological factor - a sense that expectations of profits is what permits business to go ahead with confidence. And it is in a sense pessimism, or the expectation of low profits given the new conditions, that lead businesses to contract investment.
William H. Beveridge (1909) was among the first to stress this "single underlying" factor of business expectation. Competition, he claimed, was the driving force. Any slight change in expectations of demand and profits, and every firm will attempt to increase production in order to grab the largest share first. Thus, we have a general overshooting of output. This overshooting then leads to a wave of pessimism.
Irving Fisher's (1907) cycle theory is a different case in point. He stressed that the leads and lags of adjustment are the actual creators of cycles and that these are highly influenced by psychological factors. Fisher argues that expansions emerge because "expected rate of return over cost" (i.e. expected "real" profits on investment) exceed the rate of interest. This is akin to Wicksell's division, except that Fisher argues that such an expansion arises not because there is a lot of credit, but rather, like Spiethoff, because such credit expansions are "induced" by technological improvements which then lead to expectations of profit. The mechanism by which they do so is simply that technical change raises the expected real rate of return.
Later on, Fisher (1911) abandoned this theory in part. Cycles, he claimed, come about largely by expansions in money leading to sustained rises in aggregate demand - a result that is allowed because of slow-adjusting interest rates permits demand to be continued. Why slow adjusting interest? Essentially, adjustment costs - but mostly uncertainty about the exact causes of the rise in demand is what leads them to cautiously move interest rates slowly. However, he does argue that in the long-run, when adjustment lags are overcome, the cycle is eliminated.
Later on he changed his position twice again. In the 1920s, Fisher famously claimed the cycle is merely the short-run "dance of the dollar" and was but an illusion. In 1933, Fisher came up with his "debt-deflation" theory, arguing that falling prices in a recession led a redistribution of wealth from debtors to creditors. The lower consumption propensities of creditors ensured that the demand and subsequently output was brought down.
But it was really only in Albert Aftalion Arthur C. Pigou and John M. Clark that expectations were placed as the central cause of fluctuations. Albert Aftalion's (1909, 1913) theories are famous: investment expansions are not based only on real factors such as "technological change" and an "abundance of loanable funds", but rather on the expectation by businesses of consumer demand and thus profits.
Investment decisions are driven by expectations of consumer demand, but consumer demand fluctuates according to the "gluttability" of wants that arises from diminishing marginal utility. The more consumer goods are produced, the less further demand there will be. Consequently, firms must be very careful in thinking about what stage of the cycle they are in. A rise in demand for houses may lead producers to build more houses, but by the time these houses are finished, the demand for them may no longer be as high as when the investment decision was made.
The different phases of investing and producing is what generates Aftalion's cycles. Firms make investment decisions when demand is high. Thus, they go on to produce capital goods for an extended period of time. This is prosperity, because a wave of capital goods are produced while there is high demand for consumer goods. The downswing arises, Aftalion concludes, when the investment projects are finished, generally around the same time, and a wave, a "superproduction" of consumer goods begins to come out of the newly-built factories. The declining utility of consumption ensures that demand is quickly enough saturated so that there will be a glut and the downturn begins.
The fact that capital is fixed is an important point in Aftalion. Investment will not happen during the downturn because there is no need for replacement of these relatively new capital goods. Over time, as these fixed capital goods wear out and production capacity falls below consumer demand, a wave of replacement investment ensues, bringing up incomes again. The new incomes lead to a rise in consumer goods demand, which will then call for a new wave of investment in new capital goods. The recovery is well underway and will continue until the fixed capital goods are produced and again a "superproduction" of consumer goods ensues which brings the glut and thus the downturn.
Notice that there is an accelator mechanism at work. At the trough, when replacement investment begins, this leads to an increase in income. That increase in income leads to an increase in consumer goods demand which thereby induces futher investment. But investment, as we claimed, creates income and thus induces even further increases in consumer demand, which lead to further investment. Thus, we can posit a relationship:
I(t) = b(Y(t) - Y(t-1))
investment at time t is some function of the rise in aggregate demand in the previous period. This is the acceleration principle invented by Aftalion.
John Maurice Clark independently discovered this same acceleration mechanism in his 1917 JPE article. His theory of the cycle, however, was laid out in his Strategic Factors in Business Cycles (1934). Clark's system is very akin to Aftalion's, except that he lays greater stress on dividing the "impulse" from the "propagation" mechanism. The impulse, Clark claimed, can be anything that changes consumer demand - a war, a fashion, a sudden wave of optimism. The issue is that by the acceleration mechanism, firm investment responds rapidly and quickly to any such changes in demand. Thus acceleration propagates the small initial shock into a wider and greater cycle.
Arthur C. Pigou (1920, 1927) had a more impulse-driven system and stressed the psychological factor much more than Clark. Expectations of profits, claimed Pigou, are the driving factor of investment. However, these expectations can arise easily from errors and miscalculations of entrepreneurs. These errors arise from a variety of things: there may be simply large waves of optimism and pessimism, or simply that the long gestation periods of production may exarcebate small errors into large ones. Whatever the casue, errors lead to large rises or fall in investment and this is what generates cycles.
Note the poverty of Pigou's theory in relation to Clark's: while Clark suggests that the wave of investment arises from a perfectly rational acceleration mechanism in response to a small shock, Pigou's system seems to rely on a pretty large shock which is simply not corrected on time. Clark's propagation mechanism, the accelerator, is absent in Pigou (at least in his 1927 book; his 1920 book does contain acceleration). Pigou's propogation mechanism is merely that errors cannot be detected early enough (because of long gestation) and also because ample credit facilities may encourage error to persist - e.g. errors are compounded by the fact that everyone jumps on the optimistic or pessimistic bandwagon, especially banks. Bankers may keep mistaken decisions of firms afloat and, furthermore, by their own optimism, expand that error themselves by encouraging other firms to commit the same errors.
An optimism-induced upswing ends when the superabundance of consumer goods begins to file out of factories and stay on their inventory shelves. The wave of optimism then gives way to a wave of pessimism and, again propagated by banks and other institutions, leads to a general collapse in output.