Why QE3 Will Fail

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This article
is excerpted from America’s
Great Depression
(1963), chapter 1, “The Positive Theory
of the Cycle.”

Study of
business cycles must be based upon a satisfactory cycle theory.
Gazing at sheaves of statistics without “prejudgment” is futile.
A cycle takes place in the economic world, and therefore a usable
cycle theory must be integrated with general economic theory.
And yet, remarkably, such integration, even attempted integration,
is the exception, not the rule. Economics, in the last two decades,
has fissured badly into a host of airtight compartments –
each sphere hardly related to the others. Only in the theories
of Schumpeter and Mises has cycle theory been integrated into
general economics.[1]

The bulk
of cycle specialists, who spurn any systematic integration as
impossibly deductive and overly simplified, are thereby (wittingly
or unwittingly) rejecting economics itself. For if one may forge
a theory of the cycle with little or no relation to general economics,
then general economics must be incorrect, failing as it does to
account for such a vital economic phenomenon. For institutionalists
– the pure data collectors – if not for others, this
is a welcome conclusion. Even institutionalists, however, must
use theory sometimes, in analysis and recommendation; in fact,
they end by using a concoction of ad hoc hunches, insights, etc.,
plucked unsystematically from various theoretical gardens. Few,
if any, economists have realized that the Mises theory of the
trade cycle is not just another theory: that, in fact, it meshes
closely with a general theory of the economic system.[2]
The Mises theory is, in fact, the economic analysis of
the necessary consequences of intervention in the free
market by bank credit expansion. Followers of the Misesian theory
have often displayed excessive modesty in pressing its claims;
they have widely protested that the theory is “only one of many
possible explanations of business cycles,” and that each cycle
may fit a different causal theory. In this, as in so many other
realms, eclecticism is misplaced. Since the Mises theory is the
only one that stems from a general economic theory, it is the
only one that can provide a correct explanation. Unless we are
prepared to abandon general theory, we must reject all proposed
explanations that do not mesh with general economics.

Business Cycles
and Business Fluctuations

It is important,
first, to distinguish between business cycles and ordinary
business fluctuations. We live necessarily in a society
of continual and unending change, change that can never be precisely
charted in advance. People try to forecast and anticipate changes
as best they can, but such forecasting can never be reduced to
an exact science. Entrepreneurs are in the business of forecasting
changes on the market, both for conditions of demand and of supply.
The more successful ones make profits pari passus with
their accuracy of judgment, while the unsuccessful forecasters
fall by the wayside. As a result, the successful entrepreneurs
on the free market will be the ones most adept at anticipating
future business conditions. Yet, the forecasting can never be
perfect, and entrepreneurs will continue to differ in the success
of their judgments. If this were not so, no profits or losses
would ever be made in business.

then, take place continually in all spheres of the economy. Consumer
tastes shift; time preferences and consequent proportions of investment
and consumption change; the labor force changes in quantity, quality,
and location; natural resources are discovered and others are
used up; technological changes alter production possibilities;
vagaries of climate alter crops, etc. All these changes are typical
features of any economic system. In fact, we could not truly conceive
of a changeless society, in which everyone did exactly the same
things day after day, and no economic data ever changed. And even
if we could conceive of such a society, it is doubtful whether
many people would wish to bring it about.

It is, therefore,
absurd to expect every business activity to be “stabilized” as if
these changes were not taking place. To stabilize and “iron out”
these fluctuations would, in effect, eradicate any rational productive
activity. To take a simple, hypothetical case, suppose that a community
is visited every seven years by the seven-year locust. Every seven
years, therefore, many people launch preparations to deal with the
locusts: produce anti-locust equipment, hire trained locust specialists,
etc. Obviously, every seven years there is a “boom” in the locust-fighting
industry, which, happily, is “depressed” the other six years. Would
it help or harm matters if everyone decided to “stabilize” the locust-fighting
industry by insisting on producing the machinery evenly every year,
only to have it rust and become obsolete? Must people be forced
to build machines before they want them; or to hire people before
they are needed; or, conversely, to delay building machines they
want – all in the name of “stabilization”? If people desire
more autos and fewer houses than formerly, should they be forced
to keep buying houses and be prevented from buying the autos, all
for the sake of stabilization? As Dr. F.A. Harper has stated:

This sort
of business fluctuation runs all through our daily lives. There
is a violent fluctuation, for instance, in the harvest of strawberries
at different times during the year. Should we grow enough strawberries
in greenhouses so as to stabilize that part of our economy throughout
the year.[3]

We may, therefore,
expect specific business fluctuations all the time. There
is no need for any special “cycle theory” to account for them.
They are simply the results of changes in economic data and are
fully explained by economic theory. Many economists, however,
attribute general business depression to “weaknesses” caused by
a “depression in building” or a “farm depression.” But declines
in specific industries can never ignite a general depression.
Shifts in data will cause increases in activity in one field,
declines in another. There is nothing here to account for a general
business depression – a phenomenon of the true “business
cycle.” Suppose, for example, that a shift in consumer tastes,
and technologies, causes a shift in demand from farm products
to other goods. It is pointless to say, as many people
do, that a farm depression will ignite a general depression, because
farmers will buy less goods, the people in industries selling
to farmers will buy less, etc. This ignores the fact that people
producing the other goods now favored by consumers will
prosper; their demands will increase.

The problem
of the business cycle is one of general boom and depression; it
is not a problem of exploring specific industries and wondering
what factors make each one of them relatively prosperous or depressed.
Some economists – such as Warren and Pearson or Dewey and
Dakin – have believed that there are no such things as general
business fluctuations – that general movements are but the
results of different cycles that take place, at different specific
time-lengths, in the various economic activities. To the extent
that such varying cycles (such as the 20-year “building cycle”
or the 7-year locust cycle) may exist, however, they are irrelevant
to a study of business cycles in general or to business
depressions in particular. What we are trying to explain are general
booms and busts in business.

In considering
general movements in business, then, it is immediately evident that
such movements must be transmitted through the general medium of
exchange – money. Money forges the connecting link between
all economic activities. If one price goes up and another down,
we may conclude that demand has shifted from one industry to another;
but if all prices move up or down together, some change must
have occurred in the monetary sphere. Only changes in the
demand for, and/or the supply of, money will cause general price
changes. An increase in the supply of money, the demand for money
remaining the same, will cause a fall in the purchasing power of
each dollar, i.e., a general rise in prices; conversely, a drop
in the money supply will cause a general decline in prices. On the
other hand, an increase in the general demand for money, the supply
remaining given, will bring about a rise in the purchasing power
of the dollar (a general fall in prices); while a fall in demand
will lead to a general rise in prices. Changes in prices in general,
then, are determined by changes in the supply of and demand for
money. The supply of money consists of the stock of money existing
in the society. The demand for money is, in the final analysis,
the willingness of people to hold cash balances, and this can be
expressed as eagerness to acquire money in exchange, and as eagerness
to retain money in cash balance. The supply of goods in the economy
is one component in the social demand for money; an increased supply
of goods will, other things being equal, increase the demand
for money and therefore tend to lower prices. Demand for money will
tend to be lower when the purchasing power of the money-unit is
higher, for then each dollar is more effective in cash balance.
Conversely, a lower purchasing power (higher prices) means that
each dollar is less effective, and more dollars will be needed to
carry on the same work.

The purchasing
power of the dollar, then, will remain constant when the stock
of, and demand for, money are in equilibrium with each other:
i.e., when people are willing to hold in their cash balances the
exact amount of money in existence. If the demand for money exceeds
the stock, the purchasing power of money will rise until the demand
is no longer excessive and the market is cleared; conversely,
a demand lower than supply will lower the purchasing power of
the dollar, i.e., raise prices.

Yet, fluctuations
in general business, in the “money relation,” do not by themselves
provide the clue to the mysterious business cycle. It is true
that any cycle in general business must be transmitted through
this money relation: the relation between the stock of, and the
demand for, money. But these changes in themselves explain little.
If the money supply increases or demand falls, for example, prices
will rise; but why should this generate a “business cycle”? Specifically,
why should it bring about a depression? The early business cycle
theorists were correct in focusing their attention on the crisis
and depression: for these are the phases that puzzle and
shock economists and laymen alike, and these are the phases that
most need to be explained.

The Problem:
The Cluster of Error

The explanation
of depressions, then, will not be found by referring to specific
or even general business fluctuations per se. The main problem
that a theory of depression must explain is: why is there a
sudden general cluster of business errors? This is the first
question for any cycle theory. Business activity moves along nicely
with most business firms making handsome profits. Suddenly, without
warning, conditions change and the bulk of business firms are
experiencing losses; they are suddenly revealed to have made grievous
errors in forecasting.

A general
review of entrepreneurship is now in order. Entrepreneurs are
largely in the business of forecasting. They must invest and pay
costs in the present, in the expectation of recouping a profit
by sale either to consumers or to other entrepreneurs further
down in the economy’s structure of production. The better entrepreneurs,
with better judgment in forecasting consumer or other producer
demands, make profits; the inefficient entrepreneurs suffer losses.
The market, therefore, provides a training ground for the reward
and expansion of successful, far-sighted entrepreneurs and the
weeding out of inefficient businessmen. As a rule only some businessmen
suffer losses at any one time; the bulk either break even or earn
profits. How, then, do we explain the curious phenomenon of the
crisis when almost all entrepreneurs suffer sudden losses? In
short, how did all the country’s astute businessmen come to make
such errors together, and why were they all suddenly revealed
at this particular time? This is the great problem of cycle theory.

It is not
legitimate to reply that sudden changes in the data are responsible.
It is, after all, the business of entrepreneurs to forecast future
changes, some of which are sudden. Why did their forecasts fail
so abysmally?

Another common
feature of the business cycle also calls for an explanation. It
is the well-known fact that capital-goods industries fluctuate
more widely than do the consumer-goods industries. The capital-goods
industries – especially the industries supplying raw materials,
construction, and equipment to other industries – expand
much further in the boom, and are hit far more severely in the

A third feature
of every boom that needs explaining is the increase in the quantity
of money in the economy. Conversely, there is generally, though
not universally, a fall in the money supply during the depression.

The Explanation:
Boom and Depression

In the purely
free and unhampered market, there will be no cluster of errors,
since trained entrepreneurs will not all make errors at the same
time.[4] The
“boom-bust” cycle is generated by monetary intervention in the
market, specifically bank credit expansion to business. Let us
suppose an economy with a given supply of money. Some of the money
is spent in consumption; the rest is saved and invested in a mighty
structure of capital, in various orders of production. The proportion
of consumption to saving or investment is determined by people’s
time preferences – the degree to which they prefer
present to future satisfactions. The less they prefer them in
the present, the lower will their time preference rate be, and
the lower therefore will be the pure interest rate, which
is determined by the time preferences of the individuals in society.
A lower time-preference rate will be reflected in greater proportions
of investment to consumption, a lengthening of the structure of
production, and a building-up of capital. Higher time preferences,
on the other hand, will be reflected in higher pure interest rates
and a lower proportion of investment to consumption. The final
market rates of interest reflect the pure interest rate plus or
minus entrepreneurial risk and purchasing power components. Varying
degrees of entrepreneurial risk bring about a structure
of interest rates instead of a single uniform one, and purchasing-power
components reflect changes in the purchasing power of the dollar,
as well as in the specific position of an entrepreneur in relation
to price changes. The crucial factor, however, is the pure interest
rate. This interest rate first manifests itself in the “natural
rate” or what is generally called the going “rate of profit.”
This going rate is reflected in the interest rate on the loan
market, a rate which is determined by the going profit rate.[5]

Now what
happens when banks print new money (whether as bank notes or bank
deposits) and lend it to business?[6]
The new money pours forth on the loan market and lowers the loan
rate of interest. It looks as if the supply of saved funds
for investment has increased, for the effect is the same: the
supply of funds for investment apparently increases, and the interest
rate is lowered. Businessmen, in short, are misled by the bank
inflation into believing that the supply of saved funds is greater
than it really is. Now, when saved funds increase, businessmen
invest in “longer processes of production,” i.e., the capital
structure is lengthened, especially in the “higher orders” most
remote from the consumer. Businessmen take their newly acquired
funds and bid up the prices of capital and other producers’ goods,
and this stimulates a shift of investment from the “lower” (near
the consumer) to the “higher” orders of production (furthest from
the consumer) – from consumer-goods to capital-goods industries.[7]

If this were
the effect of a genuine fall in time preferences and an increase
in saving, all would be well and good, and the new lengthened structure
of production could be indefinitely sustained. But this shift is
the product of bank credit expansion. Soon the new money percolates
downward from the business borrowers to the factors of production:
in wages, rents, interest. Now, unless time preferences have changed,
and there is no reason to think that they have, people will rush
to spend the higher incomes in the old consumption–investment
proportions. In short, people will rush to reestablish the old proportions,
and demand will shift back from the higher to the lower orders.
Capital goods industries will find that their investments have been
in error: that what they thought profitable really fails for lack
of demand by their entrepreneurial customers. Higher orders of production
have turned out to be wasteful, and the malinvestment must be liquidated.

A favorite
explanation of the crisis is that it stems from “under-consumption”
– from a failure of consumer demand for goods at prices that
could be profitable. But this runs contrary to the commonly known
fact that it is capital-goods, and not consumer-goods,
industries that really suffer in a depression. The failure is
one of entrepreneurial demand for the higher order goods,
and this in turn is caused by the shift of demand back to the
old proportions.

In sum, businessmen
were misled by bank credit inflation to invest too much in higher-order
capital goods, which could only be prosperously sustained through
lower time preferences and greater savings and investment; as
soon as the inflation permeates to the mass of the people, the
old consumption–investment proportion is reestablished, and
business investments in the higher orders are seen to have been
Businessmen were led to this error by the credit expansion and
its tampering with the free-market rate of interest.

The “boom,”
then, is actually a period of wasteful misinvestment. It is the
time when errors are made, due to bank credit’s tampering with
the free market. The “crisis” arrives when the consumers come
to reestablish their desired proportions. The “depression” is
actually the process by which the economy adjusts to the
wastes and errors of the boom, and reestablishes efficient
service of consumer desires. The adjustment process consists in
rapid liquidation of the wasteful investments. Some of
these will be abandoned altogether (like the Western ghost towns
constructed in the boom of 1816–1818 and deserted during
the Panic of 1819); others will be shifted to other uses. Always
the principle will be not to mourn past errors, but to make most
efficient use of the existing stock of capital. In sum, the free
market tends to satisfy voluntarily-expressed consumer desires
with maximum efficiency, and this includes the public’s relative
desires for present and future consumption. The inflationary boom
hobbles this efficiency, and distorts the structure of production,
which no longer serves consumers properly. The crisis signals
the end of this inflationary distortion, and the depression is
the process by which the economy returns to the efficient service
of consumers. In short, and this is a highly important point to
grasp, the depression is the “recovery” process, and the end of
the depression heralds the return to normal, and to optimum efficiency.
The depression, then, far from being an evil scourge, is the necessary
and beneficial return of the economy to normal after the distortions
imposed by the boom. The boom, then, requires a “bust.”

Since it clearly
takes very little time for the new money to filter down from business
to factors of production, why don’t all booms come quickly to an
end? The reason is that the banks come to the rescue. Seeing factors
bid away from them by consumer-goods industries, finding their costs
rising and themselves short of funds, the borrowing firms turn once
again to the banks. If the banks expand credit further, they can
again keep the borrowers afloat. The new money again pours into
business, and they can again bid factors away from the consumer-goods
industries. In short, continually expanded bank credit can keep
the borrowers one step ahead of consumer retribution. For this,
we have seen, is what the crisis and depression are: the restoration
by consumers of an efficient economy, and the ending of the distortions
of the boom. Clearly, the greater the credit expansion and the longer
it lasts, the longer will the boom last. The boom will end when
bank credit expansion finally stops. Evidently, the longer the boom
goes on the more wasteful the errors committed, and the longer and
more severe will be the necessary depression readjustment.

Thus, bank
credit expansion sets into motion the business cycle in all its
phases: the inflationary boom, marked by expansion of the money
supply and by malinvestment; the crisis, which arrives when credit
expansion ceases and malinvestments become evident; and the depression
recovery, the necessary adjustment process by which the economy
returns to the most efficient ways of satisfying consumer desires.[9]

What, specifically,
are the essential features of the depression-recovery phase? Wasteful
projects, as we have said, must either be abandoned or used as
best they can be. Inefficient firms, buoyed up by the artificial
boom, must be liquidated or have their debts scaled down or be
turned over to their creditors. Prices of producers’ goods must
fall, particularly in the higher orders of production – this
includes capital goods, lands, and wage rates. Just as the boom
was marked by a fall in the rate of interest, i.e., of price differentials
between stages of production (the “natural rate” or going rate
of profit) as well as the loan rate, so the depression-recovery
consists of a rise in this interest differential. In practice,
this means a fall in the prices of the higher-order goods relative
to prices in the consumer-goods industries. Not only prices of
particular machines must fall, but also the prices of whole aggregates
of capital, e.g., stock-market and real-estate values. In fact,
these values must fall more than the earnings from the assets,
through reflecting the general rise in the rate of interest return.

Since factors
must shift from the higher to the lower orders of production, there
is inevitable “frictional” unemployment in a depression, but it
need not be greater than unemployment attending any other large
shift in production. In practice, unemployment will be aggravated
by the numerous bankruptcies, and the large errors revealed, but
it still need only be temporary. The speedier the adjustment, the
more fleeting will the unemployment be. Unemployment will progress
beyond the “frictional” stage and become really severe and lasting
only if wage rates are kept artificially high and are prevented
from falling. If wage rates are kept above the free-market level
that clears the demand for and supply of labor, laborers will remain
permanently unemployed. The greater the degree of discrepancy, the
more severe will the unemployment be.


Various neo-Keynesians have advanced cycle theories. They are
integrated, however, not with general economic theory,
but with holistic Keynesian systems – systems which are
very partial indeed.

There is, for example, not a hint of such knowledge in Haberler’s
well-known discussion. See Gottfried Haberler, Prosperity
and Depression
(2nd ed., Geneva, Switzerland: League of
Nations, 1939).

F.A. Harper, Why
Wages Rise
(Irvington-on-Hudson, N.Y.: Foundation for
Economic Education, 1957), pp. 118–19.

Siegfried Budge, Grundzüge der Theoretische Nationalökonomie
(Jena, 1925), quoted in Simon S. Kuznets, “Monetary Business
Cycle Theory in Germany,” Journal of Political Economy
(April, 1930): 127–28.

conditions of free competition … the market is … dependent
upon supply and demand … there could [not] develop a disproportionality
in the production of goods, which could draw in the whole
economic system … such a disproportionality can arise only
when, at some decisive point, the price structure does not
base itself upon the play of only free competition, so that
some arbitrary influence becomes possible.

himself criticizes the Austrian theory from his empiricist,
anti-cause and effect-standpoint, and also erroneously considers
this theory to be “static.”

This is the “pure time preference theory” of the rate of interest;
it can be found in Ludwig von Mises, Human
(New Haven, Conn.: Yale University Press, 1949);
in Frank A. Fetter, Economic Principles (New York: Century,
1915), and idem, “Interest Theories Old and New, “American
Economic Review (March, 1914): 68–92.

“Banks,” for many purposes, include also savings and loan associations,
and life insurance companies, both of which create new money
via credit expansion to business. See below for further discussion
of the money and banking question.

On the structure of production, and its relation to investment
and bank credit, see F.A. Hayek, Prices
and Production
(2nd ed., London: Routledge and Kegan Paul,
1935); Mises, Human Action; and Eugen von Böhm-Bawerk,
“Positive Theory of Capital,” in Capital
and Interest
(South Holland, Ill.: Libertarian Press,
1959), vol. 2.

“Inflation” is here defined as an increase in the money supply
not consisting of an increase in the money metal.

This “Austrian” cycle theory settles the ancient economic controversy
on whether or not changes in the quantity of money can affect
the rate of interest. It supports the “modern” doctrine that
an increase in the quantity of money lowers the rate of interest
(if it first enters the loan market); on the other hand, it
supports the classical view that, in the long run, quantity
of money does not affect the interest rate (or can only do so
if time preferences change). In fact, the depression-readjustment
is the market’s return to the desired free-market rate of interest.

N. Rothbard
(1926–1995) was dean of the Austrian School,
founder of modern libertarianism, and chief academic officer
of the Mises Institute. He
was also editor — with Lew Rockwell — of The
Rothbard-Rockwell Report
, and appointed Lew as his literary
executor. See
his books.

2012 by the Ludwig von Mises Institute.
Permission to reprint in whole or in part is hereby granted, provided
full credit is given.

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