How the
Business Cycle Happens
by Murray N.
Rothbard
[Posted on
Tuesday, September 06, 2005]
[This
excerpt from the first chapters of Murray Rothbard's America's
Great Depression (1963) appears in celebration of full publication online.
The hard copy is also available from the Mises
Institute, introduction by Paul Johnson, for
$29. Purchase now.]
Study of
business cycles must be based upon a satisfactory cycle theory.
Gazing at sheaves of statistics without "pre-judgment" is futile. A
cycle takes place in the economic world, and therefore a usable
cycle theory must be integrated with general economic theory. And
yet, remarkably, such integration, even attempted integration, is
the exception, not the rule. Economics, in the last two decades, has
fissured badly into a host of airtight compartments — each sphere
hardly related to the others. Only in the theories of Schumpeter and
Mises has cycle theory been integrated into general
economics.[1]
The bulk
of cycle specialists, who spurn any systematic integration as
impossibly deductive and overly simplified, are thereby (wittingly
or unwittingly) rejecting economics itself. For if one may forge a
theory of the cycle with little or no relation to general economics,
then general economics must be incorrect, failing as it does to
account for such a vital economic phenomenon. For institutionalists
— the pure data collectors — if not for others, this is a welcome
conclusion. Even institutionalists, however, must use theory
sometimes, in analysis and recommendation; in fact, they end by
using a concoction of ad hoc hunches,
insights, etc., plucked unsystematically from various theoretical
gardens. Few, if any, economists have realized that the Mises theory
of the trade cycle is not just another theory: that, in fact, it
meshes closely with a general theory of the economic
system.[2] The Mises theory is, in
fact, the economic analysis of the necessary consequences of
intervention in the free market by bank credit expansion.
Followers of the Misesian theory have often displayed excessive
modesty in pressing its claims; they have widely protested that the
theory is "only one of many possible explanations of business
cycles," and that each cycle may fit a different causal theory. In
this, as in so many other realms, eclecticism is misplaced. Since
the Mises theory is the only one that stems from a general economic
theory, it is the only one that can provide a correct explanation.
Unless we are prepared to abandon general theory, we must reject all
proposed explanations that do not mesh with general
economics.
Business Cycles and Business
Fluctuations
It is
important, first, to distinguish between business cycles
and ordinary business fluctuations. We live necessarily in
a society of continual and unending change, change that can never be
precisely charted in advance. People try to forecast and anticipate
changes as best they can, but such forecasting can never be reduced
to an exact science. Entrepreneurs are in the business of
forecasting changes on the market, both for conditions of demand and
of supply. The more successful ones make profits pari passus with their accuracy of
judgment, while the unsuccessful forecasters fall by the wayside. As
a result, the successful entrepreneurs on the free market will be
the ones most adept at anticipating future business conditions. Yet,
the forecasting can never be perfect, and entrepreneurs will
continue to differ in the success of their judgments. If this were
not so, no profits or losses would ever be made in
business.
Changes,
then, take place continually in all spheres of the economy. Consumer
tastes shift; time preferences and consequent proportions of
investment and consumption change; the labor force changes in
quantity, quality, and location; natural resources are discovered
and others are used up; technological changes alter production
possibilities; vagaries of climate alter crops, etc. All these
changes are typical features of any economic system. In fact, we
could not truly conceive of a changeless society, in which everyone
did exactly the same things day after day, and no economic data ever
changed. And even if we could conceive of such a society, it is
doubtful whether many people would wish to bring it
about.
It is,
therefore, absurd to expect every business activity to be
"stabilized" as if these changes were not taking place. To stabilize
and "iron out" these fluctuations would, in effect, eradicate any
rational productive activity. To take a simple, hypothetical case,
suppose that a community is visited every seven years by the
seven-year locust. Every seven years, therefore, many people launch
preparations to deal with the locusts: produce anti-locust
equipment, hire trained locust specialists, etc. Obviously, every
seven years there is a "boom" in the locust-fighting industry,
which, happily, is "depressed" the other six years. Would it help or
harm matters if everyone decided to "stabilize" the locust-fighting
industry by insisting on producing the machinery evenly every year,
only to have it rust and become obsolete? Must people be forced to
build machines before they want them; or to hire people before they
are needed; or, conversely, to delay building machines they want —
all in the name of "stabilization"? If people desire more autos and
fewer houses than formerly, should they be forced to keep buying
houses and be prevented from buying the autos, all for the sake of
stabilization? As Dr. F.A. Harper has stated:
This
sort of business fluctuation runs all through our daily lives.
There is a violent fluctuation, for instance, in the harvest of
strawberries at different times during the year. Should we grow
enough strawberries in greenhouses so as to stabilize that part of
our economy throughout the year.[3]
We may,
therefore, expect specific business fluctuations all the
time. There is no need for any special "cycle theory" to account for
them. They are simply the results of changes in economic data and
are fully explained by economic theory. Many economists, however,
attribute general business depression to "weaknesses" caused by a
"depression in building" or a "farm depression." But declines in
specific industries can never ignite a general depression. Shifts in
data will cause increases in activity in one field, declines in
another. There is nothing here to account for a general
business depression — a phenomenon of the true "business cycle."
Suppose, for example, that a shift in consumer tastes, and
technologies, causes a shift in demand from farm products to
other goods. It is pointless to say, as many people do,
that a farm depression will ignite a general depression, because
farmers will buy less goods, the people in industries selling to
farmers will buy less, etc. This ignores the fact that people
producing the other goods now favored by consumers will
prosper; their demands will increase.
The
problem of the business cycle is one of general boom and depression;
it is not a problem of exploring specific industries and wondering
what factors make each one of them relatively prosperous or
depressed. Some economists — such as Warren and Pearson or Dewey and
Dakin — have believed that there are no such things as general
business fluctuations — that general movements are but the results
of different cycles that take place, at different specific
time-lengths, in the various economic activities. To the extent that
such varying cycles (such as the 20-year "building cycle" or the
seven-year locust cycle) may exist, however, they are irrelevant to
a study of business cycles in general or to business
depressions in particular. What we are trying to explain are
general booms and busts in business.
In
considering general movements in business, then, it is immediately
evident that such movements must be transmitted through the general
medium of exchange — money. Money forges the connecting link between
all economic activities. If one price goes up and another down, we
may conclude that demand has shifted from one industry to another;
but if all prices move up or down together, some change
must have occurred in the monetary sphere. Only changes in
the demand for, and/or the supply of, money will cause general price
changes. An increase in the supply of money, the demand for money
remaining the same, will cause a fall in the purchasing power of
each dollar, i.e., a general rise in prices; conversely, a drop in
the money supply will cause a general decline in prices. On the
other hand, an increase in the general demand for money, the supply
remaining given, will bring about a rise in the purchasing power of
the dollar (a general fall in prices); while a fall in demand will
lead to a general rise in prices. Changes in prices in general,
then, are determined by changes in the supply of and demand for
money. The supply of money consists of the stock of money existing
in the society. The demand for money is, in the final analysis, the
willingness of people to hold cash balances, and this can be
expressed as eagerness to acquire money in exchange, and as
eagerness to retain money in cash balance. The supply of goods in
the economy is one component in the social demand for money; an
increased supply of goods will, other things being equal,
increase the demand for money and therefore tend to lower prices.
Demand for money will tend to be lower when the purchasing power of
the money-unit is higher, for then each dollar is more effective in
cash balance. Conversely, a lower purchasing power (higher prices)
means that each dollar is less effective, and more dollars will be
needed to carry on the same work.
The
purchasing power of the dollar, then, will remain constant when the
stock of, and demand for, money are in equilibrium with each other:
i.e., when people are willing to hold in their cash balances the
exact amount of money in existence. If the demand for money exceeds
the stock, the purchasing power of money will rise until the demand
is no longer excessive and the market is cleared; conversely, a
demand lower than supply will lower the purchasing power of the
dollar, i.e., raise prices.
Yet,
fluctuations in general business, in the "money relation," do not by
themselves provide the clue to the mysterious business cycle. It is
true that any cycle in general business must be transmitted through
this money relation: the relation between the stock of, and the
demand for, money. But these changes in themselves explain little.
If the money supply increases or demand falls, for example, prices
will rise; but why should this generate a "business cycle"?
Specifically, why should it bring about a depression? The early
business cycle theorists were correct in focusing their attention on
the crisis and depression: for these are the
phases that puzzle and shock economists and laymen alike, and these
are the phases that most need to be explained.
The Problem: The Cluster of Error
The
explanation of depressions, then, will not be found by referring to
specific or even general business fluctuations per se. The main problem that a theory of
depression must explain is: why is there a sudden general
cluster of business errors? This is the first question for any
cycle theory. Business activity moves along nicely with most
business firms making handsome profits. Suddenly, without warning,
conditions change and the bulk of business firms are experiencing
losses; they are suddenly revealed to have made grievous errors in
forecasting.
A
general review of entrepreneurship is now in order. Entrepreneurs
are largely in the business of forecasting. They must invest and pay
costs in the present, in the expectation of recouping a profit by
sale either to consumers or to other entrepreneurs further down in
the economy's structure of production. The better entrepreneurs,
with better judgment in forecasting consumer or other producer
demands, make profits; the inefficient entrepreneurs suffer losses.
The market, therefore, provides a training ground for the reward and
expansion of successful, far-sighted entrepreneurs and the weeding
out of inefficient businessmen. As a rule only some businessmen
suffer losses at any one time; the bulk either break even or earn
profits. How, then, do we explain the curious phenomenon of the
crisis when almost all entrepreneurs suffer sudden losses? In short,
how did all the country's astute businessmen come to make such
errors together, and why were they all suddenly revealed at this
particular time? This is the great problem of cycle
theory.
It is
not legitimate to reply that sudden changes in the data are
responsible. It is, after all, the business of entrepreneurs to
forecast future changes, some of which are sudden. Why did their
forecasts fail so abysmally?
Another
common feature of the business cycle also calls for an explanation.
It is the well-known fact that capital-goods industries
fluctuate more widely than do the consumer-goods industries.
The capital-goods industries — especially the industries supplying
raw materials, construction, and equipment to other industries —
expand much further in the boom, and are hit far more severely in
the depression.
A third
feature of every boom that needs explaining is the increase in the
quantity of money in the economy. Conversely, there is generally,
though not universally, a fall in the money supply during the
depression.
The Explanation: Boom and
Depression
In the
purely free and unhampered market, there will be no cluster of
errors, since trained entrepreneurs will not all make errors at the
same time.[4] The "boom-bust" cycle is generated
by monetary intervention in the market, specifically bank credit
expansion to business. Let us suppose an economy with a given supply
of money. Some of the money is spent in consumption; the rest is
saved and invested in a mighty structure of capital, in various
orders of production. The proportion of consumption to saving or
investment is determined by people's time preferences — the
degree to which they prefer present to future satisfactions. The
less they prefer them in the present, the lower will their time
preference rate be, and the lower therefore will be the pure
interest rate, which is determined by the time preferences of
the individuals in society. A lower time-preference rate will be
reflected in greater proportions of investment to consumption, a
lengthening of the structure of production, and a building-up of
capital. Higher time preferences, on the other hand, will be
reflected in higher pure interest rates and a lower proportion of
investment to consumption. The final market rates of interest
reflect the pure interest rate plus or minus entrepreneurial risk
and purchasing power components. Varying degrees of entrepreneurial
risk bring about a structure of interest rates instead of a
single uniform one, and purchasing-power components reflect changes
in the purchasing power of the dollar, as well as in the specific
position of an entrepreneur in relation to price changes. The
crucial factor, however, is the pure interest rate. This interest
rate first manifests itself in the "natural rate" or what is
generally called the going "rate of profit." This going rate is
reflected in the interest rate on the loan market, a rate which is
determined by the going profit rate.[5]
Now what
happens when banks print new money (whether as bank notes or bank
deposits) and lend it to business?[6] The new money pours forth on the
loan market and lowers the loan rate of interest. It looks as
if the supply of saved funds for investment has increased, for
the effect is the same: the supply of funds for investment
apparently increases, and the interest rate is lowered. Businessmen,
in short, are misled by the bank inflation into believing that the
supply of saved funds is greater than it really is. Now, when saved
funds increase, businessmen invest in "longer processes of
production," i.e., the capital structure is lengthened, especially
in the "higher orders" most remote from the consumer. Businessmen
take their newly acquired funds and bid up the prices of capital and
other producers' goods, and this stimulates a shift of investment
from the "lower" (near the consumer) to the "higher" orders of
production (furthest from the consumer) — from consumer goods to
capital goods industries.[7]
If this
were the effect of a genuine fall in time preferences and an
increase in saving, all would be well and good, and the new
lengthened structure of production could be indefinitely sustained.
But this shift is the product of bank credit expansion. Soon the new
money percolates downward from the business borrowers to the factors
of production: in wages, rents, interest. Now, unless time
preferences have changed, and there is no reason to think that they
have, people will rush to spend the higher incomes in the
old consumption-investment proportions. In short, people
will rush to reestablish the old proportions, and demand will shift
back from the higher to the lower orders. Capital goods industries
will find that their investments have been in error: that what they
thought profitable really fails for lack of demand by their
entrepreneurial customers. Higher orders of production have turned
out to be wasteful, and the malinvestment must be
liquidated.
A
favorite explanation of the crisis is that it stems from
"underconsumption" — from a failure of consumer demand for goods at
prices that could be profitable. But this runs contrary to the
commonly known fact that it is capital goods, and not
consumer goods, industries that really suffer in a depression. The
failure is one of entrepreneurial demand for the higher
order goods, and this in turn is caused by the shift of demand back
to the old proportions.
In sum,
businessmen were misled by bank credit inflation to invest too much
in higher-order capital goods, which could only be prosperously
sustained through lower time preferences and greater savings and
investment; as soon as the inflation permeates to the mass of the
people, the old consumption-investment proportion is reestablished,
and business investments in the higher orders are seen to have been
wasteful.[8] Businessmen were led to this error
by the credit expansion and its tampering with the free-market rate
of interest.
The
"boom," then, is actually a period of wasteful misinvestment. It is
the time when errors are made, due to bank credit's tampering with
the free market. The "crisis" arrives when the consumers come to
reestablish their desired proportions. The "depression" is actually
the process by which the economy adjusts to the wastes and
errors of the boom, and reestablishes efficient service of
consumer desires. The adjustment process consists in rapid
liquidation of the wasteful investments. Some of these will
be abandoned altogether (like the Western ghost towns constructed in
the boom of 1816-1818 and deserted during the Panic of 1819); others
will be shifted to other uses. Always the principle will be not to
mourn past errors, but to make most efficient use of the existing
stock of capital. In sum, the free market tends to satisfy
voluntarily-expressed consumer desires with maximum efficiency, and
this includes the public's relative desires for present and future
consumption. The inflationary boom hobbles this efficiency, and
distorts the structure of production, which no longer serves
consumers properly. The crisis signals the end of this inflationary
distortion, and the depression is the process by which the economy
returns to the efficient service of consumers. In short, and this is
a highly important point to grasp, the depression is the "recovery"
process, and the end of the depression heralds the return to normal,
and to optimum efficiency. The depression, then, far from being an
evil scourge, is the necessary and beneficial return of the
economy to normal after the distortions imposed by the boom. The
boom, then, requires a "bust."
Since it
clearly takes very little time for the new money to filter down from
business to factors of production, why don't all booms come quickly
to an end? The reason is that the banks come to the rescue. Seeing
factors bid away from them by consumer goods industries, finding
their costs rising and themselves short of funds, the borrowing
firms turn once again to the banks. If the banks expand credit
further, they can again keep the borrowers afloat. The new money
again pours into business, and they can again bid factors away from
the consumer goods industries. In short, continually expanded bank
credit can keep the borrowers one step ahead of consumer
retribution. For this, we have seen, is what the crisis and
depression are: the restoration by consumers of an efficient
economy, and the ending of the distortions of the boom. Clearly, the
greater the credit expansion and the longer it lasts, the longer
will the boom last. The boom will end when bank credit expansion
finally stops. Evidently, the longer the boom goes on the more
wasteful the errors committed, and the longer and more severe will
be the necessary depression readjustment.
Thus,
bank credit expansion sets into motion the business cycle in all its
phases: the inflationary boom, marked by expansion of the money
supply and by malinvestment; the crisis, which arrives when credit
expansion ceases and malinvestments become evident; and the
depression recovery, the necessary adjustment process by which the
economy returns to the most efficient ways of satisfying consumer
desires.[9]
What,
specifically, are the essential features of the depression-recovery
phase? Wasteful projects, as we have said, must either be abandoned
or used as best they can be. Inefficient firms, buoyed up by the
artificial boom, must be liquidated or have their debts scaled down
or be turned over to their creditors. Prices of producers' goods
must fall, particularly in the higher orders of production — this
includes capital goods, lands, and wage rates. Just as the boom was
marked by a fall in the rate of interest, i.e., of price
differentials between stages of production (the "natural rate" or
going rate of profit) as well as the loan rate, so the
depression-recovery consists of a rise in this interest
differential. In practice, this means a fall in the prices of the
higher-order goods relative to prices in the consumer goods
industries. Not only prices of particular machines must fall, but
also the prices of whole aggregates of capital, e.g., stock market
and real estate values. In fact, these values must fall more than
the earnings from the assets, through reflecting the general rise in
the rate of interest return.
Since
factors must shift from the higher to the lower orders of
production, there is inevitable "frictional" unemployment in a
depression, but it need not be greater than unemployment attending
any other large shift in production. In practice, unemployment will
be aggravated by the numerous bankruptcies, and the large errors
revealed, but it still need only be temporary. The speedier the
adjustment, the more fleeting will the unemployment be. Unemployment
will progress beyond the "frictional" stage and become really severe
and lasting only if wage rates are kept artificially high and are
prevented from falling. If wage rates are kept above the free-market
level that clears the demand for and supply of labor, laborers will
remain permanently unemployed. The greater the degree of
discrepancy, the more severe will the unemployment be.
Secondary Features of Depression: Deflationary Credit
Contraction
The
above are the essential features of a depression. Other secondary
features may also develop. There is no need, for example, for
deflation (lowering of the money supply) during a
depression. The depression phase begins with the end of inflation,
and can proceed without any further changes from the side of money.
Deflation has almost always set in, however. In the first place, the
inflation took place as an expansion of bank credit; now, the
financial difficulties and bankruptcies among borrowers cause banks
to pull in their horns and contract credit.[10] Under the gold standard, banks have
another reason for contracting credit — if they had ended inflation
because of a gold drain to foreign countries. The threat of this
drain forces them to contract their outstanding loans. Furthermore
the rash of business failures may cause questions to be raised about
the banks; and banks, being inherently bankrupt anyway, can ill
afford such questions.[11] Hence, the money supply will
contract because of actual bank runs, and because banks will tighten
their position in fear of such runs.
Another
common secondary feature of depressions is an increase in the
demand for money. This "scramble for liquidity" is the result
of several factors: (1) people expect falling prices, due to the
depression and deflation, and will therefore hold more money and
spend less on goods, awaiting the price fall; (2) borrowers will try
to pay off their debts, now being called by banks and by business
creditors, by liquidating other assets in exchange for money; (3)
the rash of business losses and bankruptcies makes businessmen
cautious about investing until the liquidation process is
over.
With the
supply of money falling, and the demand for money increasing,
generally falling prices are a consequent feature of most
depressions. A general price fall, however, is caused by the
secondary, rather than by the inherent, features of depressions.
Almost all economists, even those who see that the depression
adjustment process should be permitted to function unhampered, take
a very gloomy view of the secondary deflation and price fall, and
assert that they unnecessarily aggravate the severity of
depressions. This view, however, is incorrect. These processes not
only do not aggravate the depression, they have positively
beneficial effects.
There
is, for example, no warrant whatever for the common hostility toward
"hoarding." There is no criterion, first of all, to define
"hoarding"; the charge inevitably boils down to mean that A thinks
that B is keeping more cash balances than A deems appropriate for B.
Certainly there is no objective criterion to decide when an increase
in cash balance becomes a "hoard." Second, we have seen that the
demand for money increases as a result of certain needs and values
of the people; in a depression, fears of business liquidation and
expectations of price declines particularly spur this rise. By what
standards can these valuations be called "illegitimate"? A general
price fall is the way that an increase in the demand for money can
be satisfied; for lower prices mean that the same total cash
balances have greater effectiveness, greater "real" command over
goods and services. In short, the desire for increased real cash
balances has now been satisfied.
Furthermore, the demand for money will decline again as soon
as the liquidation and adjustment processes are finished. For the
completion of liquidation removes the uncertainties of impending
bankruptcy and ends the borrowers' scramble for cash. A rapid
unhampered fall in prices, both in general (adjusting to the changed
money-relation), and particularly in goods of higher orders
(adjusting to the malinvestments of the boom) will speedily end the
realignment processes and remove expectations of further declines.
Thus, the sooner the various adjustments, primary and secondary, are
carried out, the sooner will the demand for money fall once again.
This, of course, is just one part of the general economic "return to
normal."
Neither
does the increased "hoarding" nor the fall of prices at all
interfere with the primary depression-adjustment. The important
feature of the primary adjustment is that the prices of producers'
goods fall more rapidly than do consumer good prices (or, more
accurately, that higher order prices fall more rapidly than
do those of lower order goods); it does not interfere with the
primary adjustment if all prices are falling to some degree. It is,
moreover, a common myth among laymen and economists alike, that
falling prices have a depressing effect on business. This is not
necessarily true. What matters for business is not the general
behavior of prices, but the price differentials between selling
prices and costs (the "natural rate of interest"). If wage rates,
for example, fall more rapidly than product prices, this stimulates
business activity and employment.
Deflation of the money supply (via
credit contraction) has fared as badly as hoarding in the eyes of
economists. Even the Misesian theorists deplore deflation and have
seen no benefits accruing from it.[12] Yet, deflationary credit
contraction greatly helps to speed up the adjustment
process, and hence the completion of business recovery, in ways as
yet unrecognized. The adjustment consists, as we know, of a return
to the desired consumption-saving pattern. Less adjustment is
needed, however, if time preferences themselves change:
i.e., if savings increase and consumption relatively
declines. In short, what can help a depression is not more
consumption, but, on the contrary, less consumption and more
savings (and, concomitantly, more investment). Falling
prices encourage greater savings and decreased consumption by
fostering an accounting illusion. Business accounting records the
value of assets at their original cost. It is well known that
general price increases distort the accounting-record: what seems to
be a large "profit" may only be just sufficient to replace the now
higher-priced assets. During an inflation, therefore, business
"profits" are greatly overstated, and consumption is greater than it
would be if the accounting illusion were not operating — perhaps
capital is even consumed without the individual's knowledge. In a
time of deflation, the accounting illusion is reversed: what seem
like losses and capital consumption, may actually mean profits for
the firm, since assets now cost much less to be replaced. This
overstatement of losses, however, restricts consumption and
encourages saving; a man may merely think he is replacing capital,
when he is actually making an added investment in the
business.
Credit
contraction will have another beneficial effect in promoting
recovery. For bank credit expansion, we have seen, distorts the free
market by lowering price differentials (the "natural rate of
interest" or going rate of profit) on the market. Credit
contraction, on the other hand, distorts the free market in the
reverse direction. Deflationary credit contraction's first effect is
to lower the money supply in the hands of business, particularly in
the higher stages of production. This reduces the demand for factors
in the higher stages, lowers factor prices and incomes, and
increases price differentials and the interest rate. It
spurs the shift of factors, in short, from the higher to
the lower stages. But this means that credit contraction, when it
follows upon credit expansion, speeds the market's adjustment
process. Credit contraction returns the economy to free-market
proportions much sooner than otherwise.
But, it
may be objected, may not credit contraction overcompensate the
errors of the boom and itself cause distortions that need
correction? It is true that credit contraction may overcompensate,
and, while contraction proceeds, it may cause interest rates to be
higher than free-market levels, and investment lower than in the
free market. But since contraction causes no positive
mal-investments, it will not lead to any painful period of
depression and adjustment. If businessmen are misled into thinking
that less capital is available for investment than is really the
case, no lasting damage in the form of wasted investments will
ensue.[13] Furthermore, in the nature of
things, credit contraction is severely limited — it cannot progress
beyond the extent of the preceding inflation.[14] Credit expansion faces no
such limit.
Government Depression Policy:
Laissez-Faire
If
government wishes to see a depression ended as quickly as possible,
and the economy returned to normal prosperity, what course should it
adopt? The first and clearest injunction is: don't interfere
with the market's adjustment process. The more the government
intervenes to delay the market's adjustment, the longer and more
grueling the depression will be, and the more difficult will be the
road to complete recovery. Government hampering aggravates and
perpetuates the depression. Yet, government depression policy has
always (and would have even more today) aggravated the very evils it
has loudly tried to cure. If, in fact, we list logically the various
ways that government could hamper market adjustment, we
will find that we have precisely listed the favorite
"anti-depression" arsenal of government policy. Thus, here are the
ways the adjustment process can be hobbled:
-
Prevent or delay liquidation. Lend money to shaky
businesses, call on banks to lend further, etc.
-
Inflate further. Further inflation blocks the
necessary fall in prices, thus delaying adjustment and prolonging
depression. Further credit expansion creates more malinvestments,
which, in their turn, will have to be liquidated in some later
depression. A government "easy money" policy prevents the market's
return to the necessary higher interest rates.
-
Keep wage rates up. Artificial maintenance of wage
rates in a depression insures permanent mass unemployment.
Furthermore, in a deflation, when prices are falling, keeping the
same rate of money wages means that real wage rates have been
pushed higher. In the face of falling business demand, this
greatly aggravates the unemployment problem.
-
Keep prices up. Keeping prices above their
free-market levels will create unsalable surpluses, and prevent a
return to prosperity.
-
Stimulate consumption and discourage saving. We
have seen that more saving and less consumption would speed
recovery; more consumption and less saving aggravate the shortage
of saved-capital even further. Government can encourage
consumption by "food stamp plans" and relief payments. It can
discourage savings and investment by higher taxes, particularly on
the wealthy and on corporations and estates. As a matter of fact,
any increase of taxes and government spending will discourage
saving and investment and stimulate consumption, since government
spending is all consumption. Some of the
private funds would have been saved and invested; all of
the government funds are consumed.[15] Any increase in the relative size
of government in the economy, therefore, shifts the societal
consumption-investment ratio in favor of consumption, and prolongs
the depression.
-
Subsidize unemployment. Any subsidization of
unemployment (via unemployment "insurance," relief, etc.) will
prolong unemployment indefinitely, and delay the shift of workers
to the fields where jobs are available.
These,
then, are the measures which will delay the recovery process and
aggravate the depression. Yet, they are the time-honored favorites
of government policy, and, as we shall see, they were the policies
adopted in the 1929-1933 depression, by a government known to many
historians as a "laissez-faire" administration.
Since
deflation also speeds recovery, the government should encourage,
rather than interfere with, a credit contraction. In a gold-standard
economy, such as we had in 1929, blocking deflation has further
unfortunate consequences. For a deflation increases the reserve
ratios of the banking system, and generates more confidence in
citizen and foreigner alike that the gold standard will be retained.
Fear for the gold standard will precipitate the very bank runs that
the government is anxious to avoid. There are other values in
deflation, even in bank runs, which should not be overlooked. Banks
should no more be exempt from paying their obligations than is any
other business. Any interference with their comeuppance via bank
runs will establish banks as a specially privileged group, not
obligated to pay their debts, and will lead to later inflations,
credit expansions, and depressions. And if, as we contend, banks are
inherently bankrupt and "runs" simply reveal that bankruptcy, it is
beneficial for the economy for the banking system to be reformed,
once and for all, by a thorough purge of the fractional-reserve
banking system. Such a purge would bring home forcefully to the
public the dangers of fractional-reserve banking, and, more than any
academic theorizing, insure against such banking evils in the
future.[16]
The most
important canon of sound government policy in a depression, then, is
to keep itself from interfering in the adjustment process. Can it do
anything more positive to aid the adjustment? Some economists have
advocated a government-decreed wage cut to spur employment, e.g., a
10 percent across-the-board reduction. But free-market adjustment is
the reverse of any "across-the-board" policy. Not all wages need to
be cut; the degree of required adjustments of prices and wages
differs from case to case, and can only be determined on the
processes of the free and unhampered market.[17] Government intervention can only
distort the market further.
There is
one thing the government can do positively, however: it can
drastically lower its relative role in the economy,
slashing its own expenditures and taxes, particularly taxes that
interfere with saving and investment. Reducing its tax-spending
level will automatically shift the societal
saving-investment-consumption ratio in favor of saving and
investment, thus greatly lowering the time required for returning to
a prosperous economy.[18] Reducing taxes that bear most
heavily on savings and investment will further lower social time
preferences.[19] Furthermore, depression is a time
of economic strain. Any reduction of taxes, or of any regulations
interfering with the free market, will stimulate healthy economic
activity; any increase in taxes or other intervention will depress
the economy further.
In sum,
the proper governmental policy in a depression is strict
laissez-faire, including stringent budget slashing, and coupled
perhaps with positive encouragement for credit contraction. For
decades such a program has been labeled"ignorant," "reactionary," or
"Neanderthal" by conventional economists. On the contrary, it is the
policy clearly dictated by economic science to those who wish to end
the depression as quickly and as cleanly as possible.[20]
It might
be objected that depression only began when credit expansion ceased.
Why shouldn't the government continue credit expansion indefinitely?
In the first place, the longer the inflationary boom continues, the
more painful and severe will be the necessary adjustment process,
Second, the boom cannot continue indefinitely, because eventually
the public awakens to the governmental policy of permanent
inflation, and flees from money into goods, making its purchases
while the dollar is worth more than it will be in future. The result
will be a "runaway" or hyperinflation, so familiar to
history, and particularly to the modern world.[21] Hyperinflation, on any count, is
far worse than any depression: it destroys the currency — the
lifeblood of the economy; it ruins and shatters the middle class and
all "fixed income groups"; it wreaks havoc unbounded. And
furthermore, it leads finally to unemployment and lower living
standards, since there is little point in working when earned income
depreciates by the hour. More time is spent hunting goods to buy. To
avoid such a calamity, then, credit expansion must stop sometime,
and this will bring a depression into being.
Preventing Depressions
Preventing a depression is clearly better than having to
suffer it. If the government's proper policy during a depression is
laissez-faire, what should it do to prevent a depression from
beginning? Obviously, since credit expansion necessarily sows the
seeds of later depression, the proper course for the government is
to stop any inflationary credit expansion from getting under way.
This is not a very difficult injunction, for government's most
important task is to keep itself from generating inflation.
For government is an inherently inflationary institution,
and consequently has almost always triggered, encouraged, and
directed the inflationary boom. Government is inherently
inflationary because it has, over the centuries, acquired control
over the monetary system. Having the power to print money (including
the "printing" of bank deposits) gives it the power to tap a ready
source of revenue. Inflation is a form of taxation, since the
government can create new money out of thin air and use it to bid
away resources from private individuals, who are barred by heavy
penalty from similar "counterfeiting." Inflation therefore makes a
pleasant substitute for taxation for the government officials and
their favored groups, and it is a subtle substitute which the
general public can easily — and can be encouraged to — overlook. The
government can also pin the blame for the rising prices, which are
the inevitable consequence of inflation, upon the general public or
some disliked segments of the public, e.g., business, speculators,
foreigners. Only the unlikely adoption of sound economic doctrine
could lead the public to pin the responsibility where it belongs: on
the government itself.
Private
banks, it is true, can themselves inflate the money supply by
issuing more claims to standard money (whether gold or government
paper) than they could possibly redeem. A bank deposit is equivalent
to a warehouse receipt for cash, a receipt which the bank pledges to
redeem at any time the customer wishes to take his money out of the
bank's vaults. The whole system of "fractional-reserve banking"
involves the issuance of receipts which cannot possibly be redeemed.
But Mises has shown that, by themselves, private banks could not
inflate the money supply by a great deal.[22] In the first place, each bank would
find its newly issued uncovered, or "pseudo," receipts
(uncovered by cash) soon transferred to the clients of other banks,
who would call on the bank for redemption. The narrower the
clientele of each bank, then, the less scope for its issue of
pseudo-receipts. All the banks could join together and agree to
expand at the same rate, but such agreement would be difficult to
achieve. Second, the banks would be limited by the degree to which
the public used bank deposits or notes as against standard cash; and
third, they would be limited by the confidence of the clients in
their banks, which could be wrecked by runs at any time.
Instead
of preventing inflation by prohibiting fractional-reserve banking as
fraudulent, governments have uniformly moved in the opposite
direction, and have step-by-step removed these free-market checks to
bank credit expansion, at the same time putting themselves in a
position to direct the inflation. In various ways, they have
artificially bolstered public confidence in the banks, encouraged
public use of paper and deposits instead of gold (finally outlawing
gold), and shepherded all the banks under one roof so that they can
all expand together. The main device for accomplishing these aims
has been Central Banking, an institution which America finally
acquired as the Federal Reserve System in 1913. Central Banking
permitted the centralization and absorption of gold into government
vaults, greatly enlarging the national base for credit
expansion:[23] it also insured uniform action by the
banks through basing their reserves on deposit accounts at the
Central Bank instead of on gold. Upon establishment of a Central
Bank, each private bank no longer gauges its policy according to its
particular gold reserve; all banks are now tied together and
regulated by Central Bank action. The Central Bank, furthermore, by
proclaiming its function to be a "lender of last resort" to banks in
trouble, enormously increases public confidence in the banking
system. For it is tacitly assumed by everyone that the government
would never permit its own organ — the Central Bank — to fail. A
Central Bank, even when on the gold standard, has little need to
worry about demands for gold from its own citizens. Only possible
drains of gold to foreign countries (i.e., by non-clients of the
Central Bank) may cause worry.
The
government assured Federal Reserve control over the banks by (1)
granting to the Federal Reserve System (FRS) a monopoly over note
issue; (2) compelling all the existing "national banks" to join the
Federal Reserve System, and to keep all their legal reserves as
deposits at the Federal Reserve[24]; and (3) fixing the minimum
reserve ratio of deposits at the Reserve to bank deposits (money
owned by the public). The establishment of the FRS was furthermore
inflationary in directly reducing existing reserve-ratio
requirements.[25] The Reserve could then control the
volume of money by governing two things: the volume of bank
reserves, and the legal reserve requirements. The Reserve can govern
the volume of bank reserves (in ways which will be explained below),
and the government sets the legal ratio, but admittedly control over
the money supply is not perfect, as banks can keep "excess
reserves." Normally, however, reassured by the existence of a lender
of last resort, and making profits by maximizing its assets and
deposits, a bank will keep fully "loaned up" to its legal
ratio.
While
unregulated private banking would be checked within narrow limits
and would be far less inflationary than Central Bank
manipulation,[26] the clearest way of preventing
inflation is to outlaw fractional-reserve banking, and to impose a
100 percent gold reserve to all notes and deposits. Bank cartels,
for example, are not very likely under unregulated, or "free"
banking, but they could nevertheless occur. Professor Mises, while
recognizing the superior economic merits of 100 percent gold money
to free banking, prefers the latter because 100 percent reserves
would concede to the government control over banking, and government
could easily change these requirements to conform to its
inflationist bias.[27] But a 100 percent gold reserve
requirement would not be just another administrative control by
government; it would be part and parcel of the general libertarian
legal prohibition against fraud. Everyone except absolute pacifists
concedes that violence against person and property should be
outlawed, and that agencies, operating under this general law,
should defend person and property against attack. Libertarians,
advocates of laissez-faire, believe that "governments" should
confine themselves to being defense agencies only. Fraud is
equivalent to theft, for fraud is committed when one part of an
exchange contract is deliberately not fulfilled after the other's
property has been taken. Banks that issue receipts to non-existent
gold are really committing fraud, because it is then impossible for
all property owners (of claims to gold) to claim their rightful
property. Therefore, prohibition of such practices would not be an
act of government intervention in the free market; it would
be part of the general legal defense of property against
attack which a free market requires.[28], [29]
What, then, was the proper
government policy during the 1920s? What should government have done
to prevent the crash? Its best policy would have been to liquidate
the Federal Reserve System, and to erect a 100 percent gold reserve
money; failing that, it should have liquidated the FRS and left
private banks unregulated, but subject to prompt, rigorous
bankruptcy upon failure to redeem their notes and deposits. Failing
these drastic measures, and given the existence of the Federal
Reserve System, what should its policy have been? The government
should have exercised full vigilance in not supporting or permitting
any inflationary credit expansion. We have seen that the Fed — the
Federal Reserve System — does not have complete control over money
because it cannot force banks to lend up to their reserves; but it
does have absolute anti-inflationary control over the banking
system. For it does have the power to reduce bank reserves at will,
and thereby force the banks to cease inflating, or even to contract
if necessary. By lowering the volume of bank reserves and/or raising
reserve requirements, the federal government, in the 1920s as well
as today, has had the absolute power to prevent any increase in the
total volume of money and credit. It is true that the FRS has no
direct control over such money creators as savings banks, savings
and loan associations, and life insurance companies, but any credit
expansion from these sources could be offset by deflationary
pressure upon the commercial banks. This is especially true because
commercial bank deposits (1) form the monetary base for the credit
extended by the other financial institutions, and (2) are the most
actively circulating part of the money supply. Given the Federal
Reserve System and its absolute power over the nation's money, the
federal government, since 1913, must bear the complete
responsibility for any inflation. The banks cannot inflate on their
own; any credit expansion can only take place with the support and
acquiescence of the federal government and its Federal Reserve
authorities. The banks are virtual pawns of the government, and have
been since 1913. Any guilt for credit expansion and the consequent
depression must be borne by the federal government and by it
alone.[30]
--------
Murray N. Rothbard
(1926-1995) taught at the University of Nevada, Las Vegas, and
served as vice president for academic affairs of the Mises
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