Repressed Depression

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those of you who wonder why this country keeps having recessions,
and why the retail price level never goes down, I have prepared
an answer. For those of you who think that Alan Greenspan
has finally put an end to both recessions and price inflation,
keep reading. For those of you who think that “gold is dead,”
keep reading.

Depression is the bugaboo of most Americans, far more so than
inflation. Our history textbooks from grade school through college
drum the message into the heads of the readers: the depression
of the 1930’s was the worst disaster in American economic history.
The depression proved, we are told, that laissez-faire capitalism
is unworkable in practice. President Roosevelt’s New Deal “saved
American capitalism from itself.” His administration brought
into existence a whole new complex of governmental agencies
that will supposedly be able to prevent another depression on
such a scale. By expanding their interference into the free
market, the government and the quasi-governmental central banking
system are able to “smooth out” the trade cycle.

Ironically, many of the optimistic statements coming out of
Washington in regard to the possibility of depressions are remarkably
similar to the pronouncements of statesmen and economists in
the late 1920’s. In 1931, Viking Press published a delightful
little book, Oh, Yeah?, which was a compilation of scores
of such reassurances. In retrospect, such confidence is amusing;
nevertheless, the typical graduate student in economics today
is as confident of the ability of the State to prevent a crisis
as the graduate student was in 1928. So are his professors.

This kind of thinking is dangerous. During prosperity, it convinces
men to look with favor on policies that will result in disaster.
Then when a crisis comes, unsound analyses lead to erroneous
solutions that will compound the problems. A failure to diagnose
the true cause of depressions will generally lead to the establishment
of more restrictive state controls over the economy, as bureaucrats
prescribe the only cure they understand: more bureaucracy. Mises
was correct when he argued that the statist “wants to think
of the whole world as inhabited only by officials.” The majority
of contemporary economists refuse to acknowledge that the modern
business cycle is almost invariably the product of inflationary
policies that have been permitted and/or actively pursued by
the State and the State’s licensed agencies of inflation, the
fractional reserve banks. The problem is initiated by the State
in the first place; nevertheless, the vast majority of today’s
professional economists believe that the cure for depression
is further inflation


The basic outline of the cause of the business cycle was sketched
by Ludwig von Mises in 1912, and it has been amplified by F.
A. Hayek and others since then. The explanation hinges on three
factors: the nature of free market production; the role of the
rate of interest; and the inflationary policies of the State
and the banking system, especially the latter. While no short
summary can do justice to the intricacy of some of the issues
involved, it may at least present thought for further study.

Profit is the heart of the free market’s production process.
Profits arise when capitalist entrepreneurs accurately forecast
the state of the market at some future point in time. Entrepreneurs
must organize production to meet the demand registered in the
market at that point; they must also see to it that total expenditures
do not exceed total revenue derived from sales. In other words,
if all producers had perfect foreknowledge, profits and losses
could never arise. There would be perfect competition based
upon perfect foreknowledge. This situation can never arise in
the real world, but it is the ultimate goal toward which capitalist
competition aims, since in a perfect world of this sort, there
could be no waste of scarce economic resources (given a prevailing
level of technology).

It was Mises’ life work to demonstrate that the operation of
the free market economy is the most efficient means of allocating
scarce resources in an imperfect world, Those entrepreneurs
who forecast and plan incorrectly will suffer losses; if their
errors persist, they will be driven out of business. In this
way, less efficient producers lose command over the scarce factors
of production, thus releasing such resources for use by more
efficient planners. The consumers in the economy are sovereign;
their demands are best met by an economic system which permits
the efficient producers to benefit and the inefficient to fail.

The whole structure rests upon a system of rational economic
calculation. Profits and losses must be measured against capital
expenses and other costs. The heart of the competitive capitalist
system is the flexible price mechanism. It is this which provides
entrepreneurs with the data concerning the existing state of
supply and demand. Only in this fashion can they compute the
level of success or failure of their firms’ activities.


Economic costs are varied; they include outlays for labor, raw
materials, capital equipment, rent, taxes, and interest payments.
The interest factor is really a payment for time: lenders are
willing to forego the use of their funds for a period of time;
in return, they are to be paid back their principal plus an
additional amount of money which compensates them for the consumer
goods they cannot purchase now. A little thought should reveal
why this is necessary. The economic actor always discounts future
goods. Assuming for the moment that economic conditions will
remain relatively stable, a person will take a new automobile
now rather than in the future if he is offered the choice of
delivery dates and the price is the same in both cases. The
present good is worth more simply because it can be used immediately.
Since capitalist production takes time, the capitalist must
pay interest in order to obtain the funds to be used for production.
The interest payments therefore represent a cost of production:
the capitalist is buying time. Time, in this perspective, is
a scarce resource; therefore, it commands a price.

The actual rate of interest at any point in time is a product
of many forces. Economists do not agree on all of the specific
relationships involved, and the serious student would do well
to consult Hayek’s The
Pure Theory of Capital
(1941) for an introduction to
the complexities of the issues. Nevertheless, there are some
things that we can say. First, the rate of interest reflects
the demand for money in relation to the supply of money. This
is why inflationary policies or deflationary policies have an
effect on the rate of interest: by changing the supply of money,
its price is altered. Second, the rate of interest reflects
the time preferences of the lenders, since it establishes just
how much compensation must be provided to induce savers to part
with their funds for a period of time. This is the supply side
of the equation. The demand side is the demand for capital investment.
Entrepreneurs need the funds to begin the production process
or to continue projects already begun; how much they will be
willing to pay will depend upon their expectations for future
profit. In an economy where the money supply is relatively constant,
the rate of interest will be primarily a reflection of the demand
for capital versus the time preferences of potential lenders.
Neither aspect of the rate of interest should be ignored: it
reflects both the demand for and supply of money and the demand
for and supply of capital goods.

Another factor is also present in the interest rate, the risk
factor. There are no certain investments in this world of change.
Christ’s warning against excessive reliance on treasure which
rusts or is subject to theft is an apt one (Matthew 6:19). High
risk ventures will generally command a higher rate of interest
on the market, for obvious reasons. Finally, there is the price
premium paid in expectation of mass inflation, or a negative
pressure on the interest rate in expectation of serious deflation.
It is the inflationary price premium which we are witnessing
in the United States at present. Mises’ comments in this regard
are important:

It is necessary to realize that the price premium is the outgrowth
of speculations having regard for anticipated changes in the
money relation. What induces it, in the case of the expectation
that an inflationary trend will keep on going, is already the
first sign of that phenomenon which later, when it becomes general,
is called “flight into real values” and finally produces the
crack-up boom and the crash of the monetary system concerned.


In the real world, money is never neutral (and even if it were,
the economists who explain money certainly never are). The money
supply is never perfectly constant money is hoarded, or lost;
new gold and silver come into circulation; the State’s unbacked
money is produced; deposits in banks expand or contract. These
alterations affect the so-called “real” factors of the economy;
the distribution of income, capital goods ‘ and other factors
of production are all influenced. Even more important, these
changes affect people’s expectations of the future. It is with
this aspect of inflation that Mises’ theory of the trade cycle
is concerned.

The function of the rate of interest is to allocate goods and
services between those lines of production which serve immediate
consumer demand and those which serve consumer demand in the
future. When people save, they forego present consumption, thus
releasing goods and labor for use in the expansion of production.
These goods are used to elongate the structure of production:
new techniques and more complex methods of production are added
by entrepreneurs. This permits greater physical productivity
at the end of the process, but it requires more capital or more
time-consuming processes of production, or both extra time and
added capital. These processes, once begun, require further
inputs of materials and labor to bring the production process
to completion. The rate of interest is supposed to act as an
equilibrating device. Entrepreneurs can count the cost of adding
new processes to the structure of production, comparing this
cost with expected profit. The allocation of capital among competing
uses is accomplished in a rational manner only in an economy
which permits a flexible rate of interest to do its work.

Inflation upsets the equilibrium produced by the rate of interest.
The new funds are injected into the economy at certain points.
Gold mining companies sell their product, which in turn can
be used for money; those closest to the mines get the use of
the gold first, before prices rise. But gold is not a serious
problem, especially in today’s world of credit. Its increase
is relatively slow, due to the difficulty of mining, and the
increase can be more readily predicted; hence, its influence
on the price structure is not so radical. This cannot be said,
as a general rule, for paper money and credit. Unlike gold or
silver, paper is not in a highly limited supply. It is here
that Mises argued that the business cycle is initiated. Here
— meaning the money supply — is the one central economic factor
which can account for a simultaneous collapse of so many of
the various sectors of the economy. It is the only factor common
to all branches of production.


The economic boom begins when the State or the central bank
initiates the creation of new money. (For the Western world
in this century, the establishment of this policy can generally
be dated: 1914, the outbreak of the First World War.) The central
bank, or the fractional reserve banking system as a whole, can
now supply credit to potential borrowers who would not have
borrowed before. Had the flat creation of new money not occurred,
borrowers would have had to pay a higher rate of interest in
order to obtain the additional funds. Now, however, the new
funds can be loaned out at the prevailing rate, or possibly
even a lower rate. Additional demand for money can therefore
be met without an increase in the price of money.

This elasticity of the money supply makes money unique among
scarce economic goods. It tempts both government officials and
bankers to make decisions profitable to their institutions in
the short run, but disastrous for the economy as a whole in
the longer run. Governments can expand expenditures by printing
the money directly, or by obtaining cheap loans from the central
bank, and thereby avoid the embarrassment of raising visible
taxes. Banks can create money which will earn interest and increase
profits. Mises showed that these policies must result either
in depression or mass inflation. There is no middle ground in
the long run.

As we saw earlier, the interest rate reflects both the supply
of and demand for money and the supply of and demand for capital
goods. Inflation causes this dualism to manifest itself in the
distortion of the production process. Capitalists find that
they can obtain the funds they want at a price lower than they
had expected. The new funds keep the interest rate from going
higher, and it may even drop lower, but only temporarily, i.e.,
during the boom period. In fact, one of the signals that the
boom is ending is an increase in the rate of interest.

Capitalists misinterpret this low rate of interest: what is
really merely an increase in the availability of money is seen
as an increase in the availability of capital goods and labor
services. In reality, savers have not provided the new funds
by restricting their consumption, thereby releasing capital
goods that had previously been used to satisfy consumer demand
more directly, i.e., more rapidly. Their patterns of time preference
have not been altered; they still value present goods at a higher
level than the rate of interest indicates.


Capitalists purchase goods and services with their new funds.
The price of these goods and services will therefore rise in
relation to the price of goods and services in the lower stages
of production — those closer to the immediate production of
consumer products. Labor and capital then move out of the lower
stages of production (e.g., a local restaurant or a car wash)
and into the higher stages of production (e.g., a steel mill’s
newly built branch). The process of production is elongated;
as a result, it becomes more capital-intensive. The new money
puts those who have immediate access to it at a competitive
advantage: they can purchase goods with to day’s new money at
yesterday’s lower prices; or, once the prices of producers’
goods begin to rise, they can afford to purchase these goods,
while their competitors must restrict their purchases because
their incomes have not risen proportionately. Capital goods
and labor are redistributed “upward,” toward the new money.
This is the phenomenon of “forced saving.” Those capitalists
at the lower stages of production are forced to forfeit their
use of capital goods to those in the higher stages of production.
The saving is not voluntary: it is the result of the inflation.

The result is an economic boom. More factors of production are
employed than before, as capitalists with the new funds scramble
to purchase them. Wages go up, especially wages in the capital
goods industries. More people are hired. The incumbent political
party can take credit for the “good times.” Everybody seems
to be prospering from the stimulating effects of the inflation,
Profits appear to be easy, since capital goods seem to be more
readily available than before. More capitalists therefore go
to the banks for loans, and the banks are tempted to permit
a new round of fiat credit expansion in order to avoid raising
the interest rate and stifling the boom.

Sooner or later, however, capitalists realize that something
is wrong. The costs of factors of production are rising faster
than had been anticipated. The competition from the lower stages
of production had slackened only temporarily. Now they compete
once more, since consumer demand for present goods has risen.
Higher wages are being paid and more people are receiving them.
Their old time-preference patterns reassert themselves; they
really did not want to restrict their consumption in order to
save. They want their demands met now, not at some future date.
Long-range projects which had seemed profitable before (due
to a supposedly larger supply of capital goods released by savers
for long-run investment) now are producing losses as their costs
of maintenance are increasing. As consumers spend more, capitalists
in the lower stages of production can now outbid the higher
stages for factors of production. The production structure therefore
shifts back toward the earlier, less capital-intensive patterns
of consumer preference. As always, consumer sovereignty reigns
on the free market. If no new inflation occurs, many of the
projects in the higher stages of production must be abandoned.
This is the phenomenon known as depression. It results from
the shift back to earlier patterns of consumer time preference.


The injection of new money into the economy invariably creates
a fundamental disequilibrium. It misleads entrepreneurs by distorting
the rate of interest. It need not raise the nation’s aggregate
price level, either: the inflation distorts relative prices
primarily, and the cost of living index and similar guides are
far less relevant. The depression is the market’s response to
this disequilibrium. It restores the balance of true consumer
preference with regard to the time preferences of people for
present goods in relation to future goods. In doing so, the
market makes unprofitable many of those incomplete projects
which were begun during the boom.

What is the result? Men in the higher stages of production are
thrown out of work, and not all are immediately rehired at lower
stages, especially if these workers demand wages equivalent
to those received during the inflationary boom. Yet they do
tend to demand such wages, and if governmentally protected labor
union monopolies are permitted to maintain high wage levels,
those who are not in the unions will be forced to work at even
lower pay scales, or not at all. Relative prices shift back
toward their old relationships. The demand for loans drops,
and with it goes much of the banks’ profit. The political party
in power must take responsibility for the “hard times.” Savers
may even make runs on banks to retrieve their funds, and overextended
banks will fail. This reduces the deposits in the economy, and
results in a deflationary spiral, since the deposits function
as money; the inverted pyramid of credit on the small base of
specie reserves topples. Money gets “tight.”


The depression is an absolutely inevitable result of a prior
inflation. At first, the new money kept the interest rate low;
it forced up costs in certain sectors of the economy relative
to others; the structure of production was elongated; those
employed by the higher stages then began to spend their money
on consumer goods and the shift back to a shortened production
process was the result. Everyone liked the boom (except those
on fixed incomes); no one likes the depression (except those
on fixed incomes, if the incomes keep coming in).

There is a cry for the State to do something. Banks want to
have a moratorium on all withdrawals; unions want to fix wages;
businessmen want to fix prices; everyone wants more inflation.
“Bring back the boom!” It can only be done now as before, with
flat money. The call for inflation ignores the fact that new
mal-adjustments will be created, the short-run perspective dominates.
If the cries are heeded, the price mechanism is again sacrificed,
and with it goes the system of rational calculation which makes
possible the efficiency of the free market. Mises warned a half
century ago against this policy of “repressed depression” through
inflation. Most governments since 1914 have ignored the warning,
except during the late 1920’s and early 1930’s; the depression
which resulted was “cured” by repressed depression, and that
cure is now leading to the point predicted by Mises:

The “beneficial effects” on trade of the depreciated money only
last so long as the depreciation has not affected all commodities
and services. Once the adjustment is completed, then these “beneficial
effects” disappear. If it is desired to retain them permanently,
continual resort must be had to fresh diminutions of the purchasing
power of money. It is not enough to reduce the purchasing power
of money by one set of measures only, as is erroneously supposed
by numerous inflationist writers; only the progressive diminution
of the value of money could permanently achieve the aims which
they have in view.

Here is the inescapable choice for twentieth century Western
civilization: will it be depression the readjustment of the
economy from the State-sponsored disequilibrium of supply and
demand or will it be mass inflation? The only way to escape
the depression is for the inflation to continue at an ever-increasing
rate. The result is assured: “Continued inflation must finally
end in the crackup boom, the complete breakdown of the currency
system.” The economy will go through a period of total economic
irrationality, just as the German economy did in the early 1920’s.
The German catastrophe was mitigated by support in the form
of loans from other nations; the German traditions of discipline
and thrift also played a large part. But what will be the result
if the monetary systems of the industrial nations are all destroyed
by their policies of repressed depression? What will happen
to the international trading community and its prevailing division
of labor and high productivity if the foundations of that community
— trustworthy monetary systems — are destroyed? It is questions
like these that led Charles de Gaulle’s economist, Jacques Rueff,
to conclude that the future of Western civilization hangs in
the balance.

Ours is not an age of principle. Governments would prefer to
avoid both depression and mass inflation, and so we see the
spectacle of the tightrope walk: tight money causing recession,
which is followed by easy money policies that produce inflation
and gold crises. But the trend is clear; inflation is the rule.
Hayek says that it is a question of true recovery versus the
inflationary spiral. Until we face this issue squarely, we will
not find a solution.

Men, in short, must think clearly and act courageously. They
must face the logic of economic reasoning, and admit that their
own policies of inflation have brought on the specter of depression.
They must then make a moral decision to stop the inflation.
The price system must be restored; the forced redistribution
of wealth involved in all inflation must end. If men refuse
to think clearly and to act with moral courage, then we face

I hope this analysis has helped you to understand what we are
facing today. I hope you can say to yourself, “I think I understand
economic booms and busts a little better.”

You have just read an article published 35 years ago. Since that
time, the dollar has declined in value by over 80%. Gold in 1967
was $35 per ounce. In 1967, $1,000 would have bought what it takes
$5,302 to buy today.
— inflation calculator

Nine months after my article was published, the British government
devalued the pound. Gold’s price rose. I had seen this coming.
In October, I persuaded my parents to put their savings into
American $20 gold pieces. That was the result of my having attended
the original gold investment conference, sponsored by Harry
Schultz, who is still publishing his newsletter.

As you were reading it, did the article seem far-fetched? Did
it seem dated? Could you tell how old it was? Because I removed
the footnotes, which were dated, and changed verb tenses for
people who have died since 1967 — everyone cited in my article
— it’s hard to tell when it was published. That’s my point.
The more things change, the more they stay the same — except
the purchasing power of fiat money.

I have reprinted my ancient article as an exercise in understanding
Federal Reserve policy. Fed policy never changes. The dollar
loses value, year after year.

I sit here looking at what the Federal Reserve System and the
Bank of Japan are doing to their respective economies, and I
conclude that the same old policy is still in force. The central
bankers have created a debt monster that can only be fed with
endless currency expansion. Inflation is their only available
policy to solve the nation’s macroeconomic problems. It’s Little
Shop of Horrors
in action: “Feed me, Alan.”

I argued 35 years ago that central banks create artificial and
temporary economic booms by creating new money. This newly created
money is spent into circulation by a central bank when it purchases
government debt or any other asset that is legal for the bank
to purchase. Usually, it’s government debt. When the government
gets this newly created money, it spends it into circulation.
The money is then deposited by the recipients into commercial
banks, where it multiplies by means of fractional reserves.

This expansion of money creates an economic boom or accelerates
an existing boom. Businessmen are lured into starting new projects
because of lower interest rates, which are created by the new
money. Businesses and consumers take of additional debt. This
is the basis of the employment boom.

The problem comes when the forecasts of businessmen and workers
adjust to the expectation of more fiat money and rising prices.
When most people expect the issue of continual new money, they
adjust their economic plans. The new money then no longer acts
as a shot in the arm. Fiat money really is like an addictive
drug. When the addict’s body adjusts to the higher rate of injection
of the drug, the drug loses its kick. The same is true of fiat

During the boom, most people add to their level of debt. Prices
have also ratcheted up. So have taxes, as businesses and employees
are pushed into higher marginal income tax brackets by higher
nominal (money-measured) income. Everyone has adjusted his spending
and saving plans to the new money. At that point, and stabilization
of money threatens to throw people’s expectations into the trash
can. A recession becomes likely.

Each new issue of fiat money creates distortions in the economy.
This is not a side-effect of central bank policy; it is the
sought-for effect. This is its whole purpose of fiat money.
Creating new distortions is the reason why central bankers create
new money: to overcome the negative effects — recession
— of the economy’s readjustment to the old distortions,
which were created by the previous round of monetary inflation.
For a more detailed chapter on how this process works, see Chapter
V of my mini-book, Mises on Money.


We are being lured into a massive debt pyramid that will eventually
collapse, either into deflationary depression or, more likely,
into what Mises called the crack-up boom, in which the nation’s
currency is destroyed by the central bank.

If you think the Federal Reserve has solved the nation’s economic
problems, look at its present policy: more money creation. It
has no other counter-recession policy.

The more things change, the more they stay the same.


That 1967 article was my first article to appear in a national
publication. The publication was called The Freeman.
It was a monthly magazine published by the Foundation for Economic
Education, better known as FEE. Today, FEE’s magazine is called
Ideas on Liberty. I was hired in 1971 to run FEE’s seminars.

In May, FEE will host its first national convention. When I
was Director of Seminars at FEE, a large FEE conference was
90 attendees. FEE’s national convention will feature presentations
by 50 speakers. For details, click through: www.feenational


North is the author of Mises
on Money
. To subscribe to his free
investment letter (e-mail), click here.


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