by Gary North
THE MONETARY THEORY OF THE BUSINESS CYCLE
Mises 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.
QUESTIONS 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.
Given the 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?
There is 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. Why?
IDENTIFYING THE CAUSE
The question 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.
Mises began 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.
In Chapter 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.
This discounting 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.
The objective 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.
There are 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).
The significant 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.
ALLOCATING GOODS THROUGH TIME
We live 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).
This discount "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).
If money 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).
A piece 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.
What does 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.
Will you 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.
What about 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.
The entire 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).
The same 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).
The issue 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 cycle.
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.
A borrower 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.
The banker 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.
There is 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.
Under this arrangement, the interest rate allocates goods between first-order uses and higher-order uses in terms of the free market principle, "high bid wins."
(To 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!")
DEPOSITS AND LOANS
A depositor 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.
So, bank 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.
Would-be 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."
At this 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.
The spread 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.
An 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).http://www.econlib.org/library/Mises/msT8.html
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.
The new 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.
Workers 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.
Other consumers 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.
Back in 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!")
AFTER THE BOOM, THE BUST
Mises argued 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.
(Note: in 1924, Mises called the originary rate of interest the natural rate of interest.)
The 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.
This is 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. 362-63).
It gets 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.
At 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).http: //www.econlib.org/library/Mises/msT8.html
Mises insisted 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.
The depression 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. 565).
Consumers tell producers to pay attention to what consumers really want. They communicate this information with their pocketbooks.
It 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."
According 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 credit money.
Commercial 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.
The market-enforced 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 reserve banks.
Mises wrote a brief 1936 essay in French. It was translated into English in 1978 and published in a booklet by the Center for Libertarian Studies: The Austrian Theory of the Trade Cycle and Other Essays. He concluded:
Public 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 (pp. 5-6).
Mises's 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 into disaster.
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 banks.
Ultimately, 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.
This leaves us with the perennial question: "What is to be done?" I suggest answers in the Conclusion.
January 25, 2002
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