THE MONETARY THEORY OF THE BUSINESS CYCLE
regarded his explanation of the business cycle as one of his unique
contributions to economic theory. He made more than one: the regression
theorem as the theoretical solution to the origin of money, the
socialist economic calculation dilemma, and the a priori
epistemology for economics. His theory of the monetary origin
of the business cycle, he believed in 1931, had been universally
accepted. In a 1931 book, The Causes of the Economic Crisis:
An Address, he went so far as to say: “However, a theory of
cyclical fluctuations was finally developed which fulfilled the
demands legitimately expected from a scientific solution to the
problem. This is the Circulation Credit Theory, usually called
the Monetary Theory of the Trade Cycle. This theory is generally
recognized by science. All cyclical policy measures, which are
taken seriously, proceed from the reasoning which lies at the
root of this theory” (Mises, On
the Manipulation of Money and Credit , p. 181).
Perhaps he was not overstating the case in 1931, although, academic
economists being what they are, I think he was. Today, only Misesians
still defend this theory. Among non-Austrian School economists,
hardly anyone has heard of it, few of these actually understand
it, and nobody believes it.
RAISED BY RECESSIONS
One of the
most familiar criticisms of the free market by its opponents has
been the occurrence of economic recessions and occasional economic
depressions. Critics point to economic recessions as proof that
the unhampered free market does not provide autonomous economic
stability. Despite its defenders’ claim that the free market social
order is self-regulating for the public good, economic recessions
have taken place. These recessions are marked by unemployed workers,
unemployed resources, rising rates of bankruptcy, general economic
contraction, and widespread discontent. This criticism is offered
by socialists, mixed-economy interventionists, and monetarists.
It is by far the most widely accepted criticism of capitalism.
Each group offers a different solution, but all of them are in
agreement that civil government must intervene in order to prevent
economic recessions from occurring.
existence of recurring recessions, are there modifications of
the legal order that will reduce their frequency and intensity,
or even eliminate them altogether? If the answer is yes, are these
modifications consistent with both the legal assumptions and the
economic logic of the free market social order? That is, will
these modifications so alter the legal environment that the free
market social order will be undermined, or be more likely to be
undermined, by the effects that these modifications produce? Will
the benefits produced by the reduction or elimination of recessions
exceed the costs associated with the changes in the free market
social order that the modifications will produce?
a narrower technical question that is raised by the existence
of economic recessions. If the free market is a system based on
competition among entrepreneurs, who are rewarded or punished
according to their ability to forecast the economic future and
then allocate resources profitably in terms of their plans, why
is it that so many of them make the same forecasting error? Why
do so many of them fail to forecast the coming economic setback?
Why are so few of them able to make plans that will allow them
to profit from the recession? In all other conditions, the distribution
of profits and losses is allocated by market competition more
evenly. In recessions, there are few profits and many losses.
regarding the reasons for the simultaneity of entrepreneurs’ errors
raises a subordinate question: “What is common to all entrepreneurs
in a high division of labor economy?” There is one obvious answer:
a price system that is denominated in money. Everyone in
the economy uses the same monetary system.
his discussion of the origin of the trade cycle with a discussion
of the rate of interest. The interest rate is an aspect of monetary
theory, but as he shows, interest is not exclusively an aspect
of monetary affairs. Confusion about this has led to erroneous
economic policies, such as interest-rate ceilings (usury laws)
and false explanations of the business cycle.
19 of Human
Action, Mises argued that there is always a discount in
the price of future goods compared with the price of those same
goods in the present. He called this the originary rate
of interest. It is the product of time-preference. Men
act in the present; therefore, they prefer goods in the present.
Apart from charitable impulses, the only reason why people surrender
present goods is in the hope of obtaining a greater value of future
goods, other things remaining equal.
process is applied to all goods, not just money or capital. “If
future goods were not bought and sold at a discount as against
present goods, the buyer of land would have to pay a price which
equals the sum of all future net revenues and which would leave
nothing for a current reiterated income” (p. 525). Another example:
if a gold mine is expected by all parties to produce one ounce
of gold net profit per year for one thousand years, no rational
person will pay a thousand ounces of gold, cash up front, to buy
it for its gold production. He preferred to keep the gold he already
owns. But, at some discounted price, someone will buy it.
discount of future goods against present goods that occurs in
the free market is established by the competitive bids of all
the sellers of future goods — sellers vs. sellers —
and all the competing buyers of future goods: buyers vs. buyers.
This discount is called the interest rate.
two other factors that make the free market’s interest rate. First
is the risk component. “How likely will the borrower default?”
The lender charges an extra percentage to compensate him for this
expected risk. Mises discussed this in Chapter 20, Section 2:
“The Entrepreneurial Component in the Gross Market Rate of Interest.”
(Why he uses “entrepreneurial” is a mystery. He meant risk, which
he, like Frank H. Knight, distinguished from uncertainty. According
to both of them, risk can be estimated in advance statistically.
Uncertainty cannot. Human Action, Chapter 6.) Second, there
is the inflation premium. “How much should I charge the
borrower to compensate me for the expected depreciation of the
monetary unit?” He discussed this in Section 3: “The Price Premium
as a Component of the Gross Market Rate of Interest.” He discussed
this in considerable detail in a chapter in The
Theory of Money and Credit: “The Social Consequences of
Variations in the Objective Exchange Value of Money” (pp. 195-203).
component of interest in Mises’s theory of the business cycle
is the originary rate of interest: the discount of future goods
against present goods.
GOODS THROUGH TIME
and consume in the present, but to survive through time, we need
additional resources. To secure a supply of future resources,
we sacrifice present consumption. An interest rate is the discount
that individuals place on the value of future goods compared to
present goods. This discount applies to money and everything else.
Mises said, “Originary interest is a category of human action.
It is operative in any valuation of external things and can never
disappear” (Human Action, p. 527).
“is a ratio of commodity prices, not a price in itself” (p. 526).
“Originary interest is not ‘the price paid for the services of
capital.’ . . . It is, on the contrary, the phenomenon of originary
interest that explains why less time-consuming methods of production
are resorted to in spite of the fact that more time-consuming
methods would render a higher output per unit of input” (p. 526).
Interest is not profit. Profit is the difference between the purchase
price of a good and its sale price, after having deducted the
income that would have been earned by placing the money at interest.
Profit originates in the entrepreneur’s perception — his
guess — that his competitors have underbid the price of some
resource, and that future consumers will bid more than his competitors
think (p. 535).
were neutral and prices were stable — impossible, according
to Mises (see Part
IV) — and if all borrowers always repaid on time and
in full (don’t lenders wish!), the interest rate would serve only
one purpose: to allocate today’s resources over time: from now
into the indefinite future. Some goods are consumed immediately.
Mises called these goods of the first order (p. 93). Production
goods that produce first-order goods he calls goods of the second
order (p. 94).
of bread is a first-order good. So is a piece of toast. To get
a piece of toast, you need a toaster, a second-order good, and
electricity, a second-order good (in this example). How much is
a toaster worth to you? It is worth what your subjective present
valuation of all of pieces of bread it is expected to produce,
discounted by your subjective rate of interest, i.e., your discount
on all future income.
the toaster objectively cost? It initially costs whatever an entrepreneur
has estimated that the combined money bids of all potential consumers
will be, given the competing offers from other suppliers of goods
and services. If he guessed wrong, you may be able to buy it at
a discount later.
buy the toaster? Yes, if its objective money price is no higher
than your maximum purchase price is, which you established mentally
by considering the value to you of other uses for your money in
comparison with the value of all those pieces of toast, discounted
by your personal rate of interest.
the seller who imports toasters? (If you think that most toasters
are made in America, you have not been shopping for toasters recently.)
Why did he decide to buy all of those toasters in order to make
you an offer you obviously can refuse? Because he believed that
you and a lot of people just like you would be willing to pay
for his toasters at a retail price. He looked at the cost of importing,
marketing, and delivering toasters. He estimated the gross revenue
from the sale of these toasters. Then he looked at the cost of
borrowing money for the time period that concerned him: from his
payment to the exporting firm to the sale of the toasters. The
market rate of interest was a factor in his decision. Had it been
so high that it would have reduced his expected profits on the
entire deal, he would not have become a toaster distributor. It
was low enough to enable him to make a profit, assuming that he
was buying smart and he did not think you and the others would
buy even smarter.
As a potential
present buyer of a second-order good (toaster), you apply your
discount rate to future first-order goods (toast). As a potential
seller of future second-order goods (toasters), he has applied
the relevant discount rate: the free market’s objective rate of
interest. Whether you and he can work out an exchange depends
on your discount rate (applied to your toast), the market’s discount
rate (applied to his entrepreneurial plan), and the price of imported
toasters vs. the expected retail price. Oh, yes: one other thing:
his competition, meaning everything else that you could use your
money to buy.
production process is a series of individual decisions to allocate
present goods to their highest uses. Some goods are directly consumed
now (bread). Others are directly consumed later (toast). Some
are never directly consumed (toasters). They are used to produce
goods that are directly consumed (toast). Other goods — goods
of a higher order — are used to produce things (steel) that
are used to produce second-order goods (toasters).
market rate of interest applies to every good during the same
time period. If it takes ten years to build a production facility
and pay off the loan, then the relevant rate of interest is the
ten-year rate. This rate applies equally to every type of production
facility that takes ten years to pay off. Whether the facility
makes steel or produces chemicals is economically irrelevant to
lenders (assuming equal risks of default).
here is goods, not money. “You can’t eat gold!” Also, you can’t
eat Federal Reserve Notes, credit cards, and IOU’s from your big-mouth
brother-in-law, Harry. But in a money economy, loans are made
in terms of money. Therein lies the problem of origin of the trade
A bank makes
loans. A depositor goes to a bank to make a deposit. In a low-risk
transaction that does not involve fractional reserves, the depositor
would decide what length of time he is willing to forfeit the
use of his money. He would then deposit the money. He would not
be able to get his money until the due date.
would also go to the bank. He would borrow the money for that
same length of time. The banker would arrange the temporary exchange
of funds, making his rate of return on the spread: what he pays
the lender vs. what the borrower pays him.
acts as an intermediary. He has information about lending risks.
He has information about attracting depositors. He makes his money
based on this specialized information.
no inflation of the money supply. What the borrower receives,
the depositor gives up. The borrower then goes out with his newly
borrowed money and bids for goods of a second order (if this is
a commercial loan) or goods of the first order (if this is a consumer
loan). The depositor cannot bid for any goods. He has forfeited
the use of his money.
arrangement, the interest rate allocates goods between first-order
uses and higher-order uses in terms of the free market principle,
“high bid wins.”
analyze any economic problem, you only need a pair of parrots,
one on each shoulder. One is trained to say, “Supply and demand!
Supply and demand!” The other says, “High bid wins!” The trick
is to listen to them in the correct order, and also to avoid getting
dumped on, either by the parrots or economists with their parrots,
who are trained to say, “Unfair initial distribution!” and “In
the long run, we’re all dead!”)
makes a deposit. The banker has a new supply of money: a deposit.
To make any money on this deal, he has to persuade a borrower
to take on a new debt. How does he do this? After all, if the
borrower wanted access to the money at today’s interest rate,
he would have borrowed it this morning. What to do? What to do?
Of course! Lower the interest rate. Make him a better deal.
by bank, deposit by deposit, 97% of the total, bankers seek out
new borrowers by making them a better deal: a lower interest rate.
And borrowers respond to the offer. Every dime gets lent. Every
dime has to get lent if the banker wants to make any money on
the deal. There are no cookie jars in banks.
borrowers see lower interest rates available, and they say to
themselves, “I can put that money to profitable use. I couldn’t
at the older, higher rate, but I can now.”
point, Mises argued, borrowers make errors. They assume, because
interest rates are lower, that there has been an increase in demand
for future goods. In other words, present-oriented lenders have
become less present-oriented. They have decided, “I want additional
future goods. I am willing to forfeit the purchase of present
consumer goods — sacrifice, in other words — in order
to obtain a larger supply of future goods.” But the depositors
have an ace in the hole: they can change their minds overnight
and withdraw their money on demand. They have been promised this
by the bankers and the FDIC and Congress and the entire economics
profession, except for Austrian School weirdos. They have not
agreed contractually to do without consumption goods for
the duration of the entire period of the loan. Rather, they have
agreed to do without their money until they change their
minds. They and the banks agreed to this arrangement “for the
duration” — however brief the duration may turn out to be.
of money, you may recall — by now, you had jolly well better
recall! — is not neutral. New users get access to it before
it loses purchasing power. The cash-induced wealth-redistribution
process begins. It shifts demand for from first-order goods to
higher-order goods. It subsidizes investment. Mises described
this in Theory of Money and Credit.
increase in the stock of money in the broader sense caused by
an issue of fiduciary media means a displacement of the social
distribution of property in favor of the issuer. If the fiduciary
media are issued by the banks, then this displacement is particularly
favorable to the accumulation of capital, for in such a case the
issuing body employs the additional wealth that it receives solely
for productive purposes, whether directly by initiating and carrying
through a process of production or indirectly by lending to producers.
Thus, as a rule, the fall in the rate of interest in the loan
market, which occurs as the most immediate consequence of the
increase in the supply of present goods that is due to an issue
of fiduciary media, must be in part permanent; that is, it will
not be wiped out by the reaction that is afterward caused by the
diminution of the property of other persons. There is a high degree
of probability that extensive issues of fiduciary media by the
banks represent a strong impulse toward the accumulation of capital
and have consequently contributed to the fall in the rate of interest.
One thing must be clearly stated at this point: there is no direct
arithmetical relationship between an increase or decrease in the
issue of fiduciary media on the one hand and the reduction or
increase in the rate of interest which this indirectly brings
about through its effects on the social distribution of property
on the other hand. This would follow merely from the circumstance
that there is no direct relationship between the redistribution
of property and the differences in the way in which the existing
stock of goods in the community is employed. The redistribution
of property causes individual economic agents to take different
decisions from those they would otherwise have taken. They deal
with the goods at their disposal in a different way; they allocate
them differently between present (consumptive) employment and
future (productive) employment (pp. 349-50).
If the new
money goes to producers rather than consumers, there is an increase
of demand for, and then production of, investment goods. But investment
goods are not liquid assets. They are not the most marketable
commodity. In short, they are not money. They are not like a depositor’s
bank account, withdrawable on demand.
money produces a boom in production goods, i.e., a capital equipment
boom. Had consumers been willing to forego consumption for a period,
such as would be required to issue a 30-year mortgage, this would
not be a problem. It would be what consumers really wanted: an
increase in future goods in exchange for the consumption and use
of present goods. But the banking system is not a 100% reserve
system in which credit is matched by debt, both in magnitude and
duration. It is a fractionally reserved system. It is borrowed
short and lent long. It is also inflationary.
So, in terms
of what consumers really want, industry is now malinvested. It
is loaded up with illiquid goods of a higher order. Consumers
were willing to turn over their money to borrowers by way of the
banking system, but only given the price conditions that prevailed
at the time. These circumstances now begin to change as a result
of the new fractional reserve-created money.
who are employed by the capital goods industry now have newly
created money to burn. Employment is booming. Their response is
predictable: “Let’s party!” They start buying consumption goods.
The uneven spread of money and prices continues to have its wealth-redistribution
effects. The process accelerates.
see what is happening to prices. Workers who work in the first-order
(consumer) goods industries see demand rising. They also conclude:
“Let’s party.” The new money spreads. As it spreads, prices start
rising — prices of consumer goods. Other consumers see this,
and they conclude: “If I don’t buy now, it will cost me more,
later.” They start buying.
1924, let alone 1912, the consumer credit market was a dream of
Madison Avenue marketers and General Motors’s Alfred Sloan. Europeans
knew nothing about such a market. By the time he wrote Human
Action, Mises should have recognized this new market’s effects
on his theory of credit money’s subsidy of producer goods. He
did not mention this, however. There remains therefore a gaping
hole in Mises’s theory of the trade cycle: consumer credit. Its
absence affects the front end of his analysis: where the newly
created money gets injected. It also affects the middle of his
analysis: the ability of consumers to borrow money to get into
the bidding process for consumer goods vs. producer goods. (“High
bid wins!”) I do not have space here to suggest a modification
of his theory, but consumer credit surely makes matters more complex.
When a consumer is willing to pay 18% or more for a loan, he becomes
a strong competitor with a businessman, who knows that 11% is
the outside limit for his proposed venture. (“High bid wins!”)
THE BOOM, THE BUST
that the bust — contraction — is caused by the decisions
of consumers to start buying consumer goods earlier than expected
by most entrepreneurs. This disrupts the plans of producers, who
are caught short with uncompleted projects and rising interest
rates. Producers learn painfully that their capital investments
had been wrong. The artificially low interest rates created by
the expansion of fiduciary money misled them. The consumers really
had not become future-oriented. They really were not willing to
sacrifice the use of present goods in favor of an increased supply
of future goods. The consumers have not changed their minds. Their
minds never changed. Depositors were misled by bankers, who offered
them an impossible dream: to have their cake (at 3% per annum)
and eat it too. Now they are eating their cake. As a result, the
producers are eating their lunch. In the chapter on “Money, Credit,
and Interest,” Mises summarized the boom and bust cycle.
1924, Mises called the originary rate of interest the natural
rate of interest.)
situation is as follows: despite the fact that there has been
no increase of intermediate products and there is no possibility
of lengthening the average period of production, a rate of interest
is established in the loan market which corresponds to a longer
period of production; and so, although it is in the last resort
inadmissible and impracticable, a lengthening of the period of
production promises for the time to be profitable. But there cannot
be the slightest doubt as to where this will lead. A time must
necessarily come when the means of subsistence available for consumption
are all used up although the capital goods employed in production
have not yet been transformed into consumption goods. This time
must come all the more quickly inasmuch as the fall in the rate
of interest weakens the motive for saving and so slows up the
rate of accumulation of capital. The means of subsistence will
prove insufficient to maintain the laborers during the whole period
of the process of production that has been entered upon. Since
production and consumption are continuous, so that every day new
processes of production are started upon and others completed,
this situation does not imperil human existence by suddenly manifesting
itself as a complete lack of consumption goods; it is merely expressed
in a reduction of the quantity of goods available for consumption
and a consequent restriction of consumption. The market prices
of consumption goods rise and those of production goods fall.
one of the ways in which the equilibrium of the loan market
is reestablished after it has been disturbed by the intervention
of the banks. The increased productive activity that sets in
when the banks start the policy of granting loans at less than
the natural rate of interest at first causes the prices of production
goods to rise while the prices of consumption goods, although
they rise also, do so only in a moderate degree, namely, only
insofar as they are raised by the rise in wages. Thus the tendency
toward a fall in the rate of interest on loans that originates
in the policy of the banks is at first strengthened. But soon
a countermovement sets in: the prices of consumption goods rise,
those of production goods fall. That is, the rate of interest
on loans rises again, it again approaches the natural rate (pp.
worse. The interest rate in the initial contraction phase must
rise above what it had been prior to the expansion of fiduciary
media. One reason is that the price level has risen. “This counter-movement
is now strengthened by the fact that the increase of the stock
of money in the broader sense that is involved in the increase
in the quantity of fiduciary media reduces the objective exchange
value of money. Now, as has been shown, so long as this depreciation
of money is going on, the rate of interest on loans must rise
above the level that would be demanded and paid if the objective
exchange value of money remained unaltered” (p. 363). A second
reason, which Mises did not mention, is that the risk premium
probably rises. More companies are facing bankruptcy. The risk
of commercial lending has risen.
first the banks may try to oppose these two tendencies that counteract
their interest policy by continually reducing the rate of interest
charged for loans and forcing fresh quantities of fiduciary media
into circulation. But the more they thus increase the stock of
money in the broader sense, the more quickly does the value of
money fall, and the stronger is its counter-effect on the rate
of interest. However much the banks may endeavor to extend their
credit circulation, they cannot stop the rise in the rate of interest.
Even if they were prepared to go on increasing the quantity of
fiduciary media until further increase was no longer possible
(whether because the money in use was metallic money and the limit
had been reached below which the purchasing power of the money-and-credit
unit could not sink without the banks being forced to suspend
cash redemption, or whether because the reduction of the interest
charged on loans had reached the limit set by the running costs
of the banks), they would still be unable to secure the intended
result. For such an avalanche of fiduciary media, when its cessation
cannot be foreseen, must lead to a fall in the objective exchange
value of the money-and-credit unit to the panic-like course of
which there can be no bounds. Then the rate of interest on loans
must also rise in a similar degree and fashion (pp. 363).
that “The essence of the credit-expansion boom is not overinvestment,
but investment in the wrong lines, i.e., malinvestment” (Human
Action, p. 559). The price of all that misallocated capital
— illiquid goods of a higher order — must change. The
illiquid goods must be either put to lower productive uses or
liquidated. How does a businessman get liquid? At a fire sale.
Mises described it. “However, raw materials, primary commodities,
half-finished manufactures and foodstuffs are not lacking at the
turning point at which the upswing turns into depression. On the
contrary, the crisis is precisely characterized by the fact that
these goods are offered in such quantities as to make their prices
drop sharply” (p. 560).
I have used
the example of rising prices, but rising prices need not be present
in order for Mises’s theory to apply. Fractional reserve bank
credit is sufficient to cause the boom in malinvested capital.
Prices may not rise. They otherwise would have fallen. On this
issue, Mises agreed with Murray Rothbard’s assessment of the boom
of 1926-29: it was not marked by a rise in prices, but the malinvestment
of capital did take place. In the 1966 edition of Human Action,
Mises wrote: “As a rule the resultant clash of opposite forces
was a preponderance of those producing a rise in prices. But there
were some exceptional instances too in which the upward movement
of prices was only slight. The most remarkable example was provided
by the American boom of 1926-29″ (p. 561). In a footnote, Mises
cited Rothbard’s book, America’s
Great Depression (1963). On the question of the cause
of America’s great depression, Mises was a Rothbardian.
They both agreed: the cause was monetary policies of the Federal
Reserve System — not after the depression began, but before.
is the free market’s means of re-pricing goods in terms of the
consumers’ real priorities between present and future goods. It
is not the depression that impoverishes people. It was the boom.
“The boom produces impoverishment” (p. 576). By this, he means
“impoverishment as compared with the state of affairs which would
have developed in the absence of credit expansion and boom” (p.
tell producers to pay attention to what consumers really want.
They communicate this information with their pocketbooks.
is essential to realize that what makes the economic crisis emerge
is the democratic process of the market. The consumers disapprove
of the employment of the factors of production as effected by
the entrepreneurs. They manifest their disapprobation by their
conduct in buying and abstention from buying. The entrepreneurs,
misled by the illusions of the artificially lowered gross market
rate of interest, have failed to invest in those lines in which
the most urgent needs of the public would have been satisfied
in the best possible way. As soon as the credit expansion comes
to an end, these faults become manifest. The attitudes of the
consumers force the businessmen to adjust their activities anew
to the best possible want-satisfaction (p. 565).
If the public
as voters demand that the politicians or central bankers indulge
their proclivities for another round of inflation, the boom-bust
cycle is extended for another round. So, the real culprits are
the voters, who vote to undermine their sovereignty as consumers.
In short, says Mises, “the people are incorrigible. After a few
years they embark anew upon credit expansion and the old story
repeats itself” (p. 578). As Pogo Possum said, “We have met the
enemy, and he is us.”
to Mises’s theory of the business cycle, the free market is not
the source of economic contraction, namely, recessions and depressions.
The source is the fractional reserve banking system, which is
favored by the State. The State licenses a monopolistic central
bank — fractionally reserved — which sets monetary policy
by buying or selling debt. The commercial banks lend in terms
of the reserves created by central bank debt holdings. The central
bank and the government protect commercial banks from bank runs
by depositors. The State does not enforce the laws of contract
as its way to reduce the risk to depositors from default by their
over-extended banks. Instead, it protects the banks by creating
a special category of contract: the non-enforcement of contract.
Then the State increases the profligacy of the bankers by creating
a system of government-insured bank deposits. Although Mises did
not mention State-provided deposit insurance, he would have seen
it for what it is: a device to protect those over-extended banks
that default. The State-guaranteed insurance system is a means
to persuade the depositors not to worry about unsound banking
practices. This reduces the threat of bank runs, i.e., the depositors’
means of restricting the banks’ issuing of highly leveraged inflationary
bank inflation causes the economic boom, which persuades capitalists
to misallocate capital, including capital purchased with bank
debt. Commercial bank inflation produces this widespread error
among entrepreneurs by temporarily lowering the market interest
rate below the originary rate, i.e., the rate which allocates
the production of present goods vs. future goods in terms of consumer
demand for both forms of goods. The discount of future goods against
present goods that is established by competing consumers is concealed
to entrepreneurs by the interest-rate effects of the newly created
fractional reserve—created money that is issued by commercial
banks. The temporarily lower rate of interest misinforms capitalist
entrepreneurs regarding the investors’ true discount of future
goods. Capitalist entrepreneurs are misled to believe that savers
are more future-oriented than they really are. When the new money
raises consumer incomes and then consumer prices, savers reassert
their original higher time-preference by buying consumer goods.
This disrupts the plans of the now debt-burdened capitalists,
who find themselves over-extended. They had thought that consumers
wanted to save. Instead, consumers want to spend, and the boom
has provided them with new money to spend.
readjustment of prices — consumer goods vs. capital goods
— is called a recession. It is the outcome of a prior State-authorized
expansion by commercial banks of the supply of credit money. It
is the free market’s response to a prior interference of the free
market’s money supply by State-licensed, State-protected fractional
a brief 1936 essay in French. It was translated into English in
1978 and published in a booklet by the Center for Libertarian
Austrian Theory of the Trade Cycle and Other Essays. He
opinion is perfectly right to see the end of the boom and the
crisis as a consequence of the policy of the banks. The banks
could undoubtedly have delayed the unfavorable developments for
some further time. They could have continued their policy of credit
expansion for a while. But — as we have already seen —
they could not have persisted in it indefinitely. The boom brought
about by the banks’ policy of extending credit must necessarily
end sooner or later. Unless they are willing to let their policy
completely destroy the monetary and credit system, the banks themselves
must cut it short before the catastrophe occurs. The longer the
period of credit expansion and the longer the banks delay in changing
their policy, the worse will be the consequences of the malinvestments
and the inordinate speculation characterizing the boom; and as
a result the longer will be the period of depression and the more
uncertain the date of recovery and return to normal economic activity
theory of the business cycle places secondary responsibility for
the boom, with all of its malinvestment, on the profit-seeking
bankers who use the fractional reserve banking system to create
interest-bearing credit money. His theory places greater responsibility
on the politicians. By legalizing special exemptions for bankers
with respect to the obligation to honor contracts, the politicians
have undermined the free market’s early phase negative sanctions
against over-extended fractionally reserved banks. Instead, the
later-phase sanctions come into play: the bust, unemployment,
and the bankruptcy of businesses and the banks that lured them
To the extent
that a national government adds another layer of protection from
free market sanctions in the form of a central bank cartel that
has the power to issue money — sometimes called high-powered
money, because it serves as legal reserve for the expansion of
commercial bank credit — responsibility shifts from commercial
bankers to central bankers. Mises was a great opponent of central
citizens are to blame. They think that they can get something
for nothing. They think that they can make themselves wealthier
by spending newly created credit money. They have two generations
of Keynesian economists telling them that they really can do this.
They are present-orientated. In Mises’s terminology, they have
high time-preference. They have a willingness to go into debt
at high interest. They place a high discount on future goods.
Whenever there is a slowdown in the increase of fractionally reserved
credit money, their high time-preference produces a recession.
Then consumers, in their legal capacity as voters, tell the politicians
to Do Something. The politicians in turn call on the central bank
to create more money and thereby lower interest rates, in order
to restore the economic boom. The central bank opens up the high-powered
money spigot even wider by buying government debt. The Treasury
spends the new money into circulation, and the recipients deposit
it in their local banks. The commercial banks start lending their
newly created credit money to anyone who will take on more debt.
The money gets spent by the borrowers. The recipients bid up prices.
The central bank then ceases to create new high-powered money,
so as not to destroy the currency unit by inflating. Another recession
occurs. And the beat goes on. And the beat goes on.
us with the perennial question: “What is to be done?” I suggest
answers in the Conclusion.
on Money: Part 1
on Money: Part 2
on Money: Part 3
on Money: Part 4
on Money: Conclusion
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