Human Action: A Treatise on Economics

by Ludwig VonMises

  Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion goes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

  While the boom is in progress, there prevails a general tendency to buy as much as one can buy because a further rise in prices is anticipated. In the depression, on the other hand, people abstain from buying because they expect that prices will continue to drop. The recovery and the return to “normalcy” can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more. Therefore the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates.

  Only when the recovery begins to take shape does the change in the money relation, as effected by the increase in the quantity of fiduciary media, begin to manifest itself in the structure of prices.

  The Difference Between Credit Expansion and Simple Inflation

  In dealing with the consequences of credit expansion we assumed that the total amount of additional fiduciary media enters the market system via the loan market as advances to business. All that has been predicated with regard to the effects of credit expansion refers to this condition.

  There are, however, instances in which the legal and technical methods of credit expansion are used for a procedure catallactically utterly different from genuine credit expansion. Political and institutional convenience sometimes makes it expedient for a government to take advantage of the facilities of banking as a substitute for issuing government fiat money. The treasury borrows from the bank, and the bank provides the funds needed by issuing additional banknotes or crediting the government on a deposit account. Legally the bank becomes the treasury’s creditor. In fact the whole transaction amounts to fiat money inflation. The additional fiduciary media enter the market by way of the treasury as payment for various items of government expenditure. It is this additional government demand that incites business to expand its activities. The issuance of these newly created fiat money sums does not directly interfere with the gross market rate of interest, whatever the rate of interest may be which the government pays to the bank. They affect the loan market and the gross market rate of interest, apart from the emergence of a positive price premium, only if a part of them reaches the loan market at a time at which their effects upon commodity prices and wage rates have not yet been consummated.

  Such were, for example, the conditions in the United States in the second World War. Apart from the credit expansion policy, which the Administration had already adopted before the outbreak of the war, the government borrowed heavily from the commercial banks. This was technically credit expansion; essentially it was a substitute for the issuance of greenbacks. Even more complicated techniques were resorted to in many countries. Thus, for instance, the German Reich in the first World War sold bonds to the public. The Reichsbank financed these purchases by lending the greater part of the funds needed to the buyers against the same bonds as collateral. Apart from the fraction which the buyer contributed from his own funds, the role that the Bank and the public played in the whole transaction was merely formal. Virtually, the additional banknotes were inconvertible paper money.

  It is important to pay heed to these facts in order not to confuse the consequences of credit expansion proper and those of governmentmade fiat money inflation.

  8. The Monetary or Circulation Credit Theory of the Trade Cycle

  The theory of the cyclical fluctuations of business as elaborated by the British Currency School was in two respects unsatisfactory.

  First it failed to recognize that circulation credit can be granted not only by the issue of banknotes in excess of the banks’ holding of cash reserves, but also by creating bank deposits subject to check in excess of such reserves (checkbook money, deposit currency). Consequently it did not realize that deposits payable on demand can also be used as a device of credit expansion. This error is of little weight, as it can be easily amended. It is enough to stress the point that all that refers to credit expansion is valid for all varieties of credit expansion no matter whether the additional fiduciary media are banknotes or deposits. However, the teachings of the Currency School inspired British legislation designed to prevent the return of credit-expansion booms and their necessary consequence, depressions, at a time when this fundamental defect was not yet unmasked. Peel’s Act of 1844 and its imitations in other countries did not attain the ends sought, and this failure shook the prestige of the Currency School. The Banking School triumphed undeservedly.

  The second shortcoming of the Currency Theory was more momentous. It restricted its reasoning to the problem of the external drain. It dealt only with a particular case, viz., credit expansion in one country only while there is either no credit expansion or only credit expansion to a smaller extent in other areas. This was, by and large, sufficient to explain the British crisis of the first part of the nineteenth century. But it touched only the surface of the problem. The essential question was not raised at all. Nothing was done to clarify the consequences of a general expansion of credit not confined to a number of banks with a restricted clientele. The reciprocal relations between the supply of money (in the broader sense) and the rate of interest were not analyzed. The multifarious projects to lower or to abolish interest altogether by means of a banking reform were haughtily derided as quackery, but not critically dissected and refuted. The naïve presumption of money’s neutrality was tacitly ratified. Thus a free hand was left to all futile attempts to interpret crises and business fluctuations by means of the theory of direct exchange. Many decades passed before the spell was broken.

  The hindrance that the monetary or circulation credit theory had to overcome was not merely theoretical error but also political bias. Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation. In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy. As has been mentioned already, the British Government has asserted that credit expansion has performed “the miracle … of turning a stone into bread.” 10 A Chairman of the Federal Reserve Bank of New York has declared that “final freedom from the domestic money market exists for every sovereign national state where there exists an institution which functions in the manner of a modern central bank, and whose currency is not convertible into gold or into some other commodity.”11 Many governments, universities, and institutes of economic research lavishly subsidize publications whose main purpose is to praise the blessings of unbridled credit expansion and to slander all opponents as ill-intentioned advocates of the selfish interests of usurers.

  The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and
total catastrophe of the currency system involved.

  The only objection ever raised against the circulation credit theory is lame indeed. It has been asserted that the lowering of the gross market rate of interest below the height it would have reached on an unhampered loan market may appear not as the outcome of an intentional policy on the part of the banks or the monetary authorities but as the unintentional effect of their conservatism. Faced with a situation which would, when left alone, result in a raise in the market rate, the banks refrain from altering the interest they charge on advances and thus willy-nilly tumble into expansion.12 These assertions are unwarranted. But if we are prepared to admit their correctness for the sake of argument, they do not affect at all the essence of the monetary explanation of the trade cycle. It is of no concern what the particular conditions are that induce the banks to expand credit and to underbid the gross market rate of interest which the unhampered market would have determined. What counts is solely that the banks and the monetary authorities are guided by the idea that the height of interest rates as the free loan market determines it is an evil, that it is the objective of a good economic policy to lower it, and that credit expansion is an appropriate means of achieving this end without harm to anybody but parasitic moneylenders. It is this infatuation that causes them to embark upon ventures which must finally bring about the slump.

  If one takes these facts into consideration one could be tempted to abstain from any discussion of the problems involved in the frame of the theory of the pure market economy and to relegate it to the analysis of interventionism, the interference of government with the market phenomena. It is beyond doubt that credit expansion is one of the primary issues of interventionism. Nevertheless the right place for the analysis of the problems involved is not in the theory of interventionism but in that of the pure market economy. For the problem we have to deal with is essentially the relation between the supply of money and the rate of interest, a problem of which the consequences of credit expansion are only a particular instance.

  Everything that has been asserted with regard to credit expansion is equally valid with regard to the effects of any increase in the supply of money proper as far as this additional supply reaches the loan market at an early stage of its inflow into the market system. If the additional quantity of money increases the quantity of money offered for loans at a time when commodity prices and wage rates have not yet been completely adjusted to the change in the money relation, the effects are no different from those of a credit expansion. In analyzing the problem of credit expansion, catallactics completes the structure of the theory of money and of interest. It implicitly demolishes the age-old errors concerning interest and explodes the fantastic plans to “abolish” interest by means of monetary or credit reform.

  What differentiates credit expansion from an increase in the supply of money as it can appear in an economy employing only commodity money and no fiduciary media at all is conditioned by divergences in the quantity of the increase and in the temporal sequence of its effects on the various parts of the market. Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures.13 The gold standard’s own inflationary potentialities were kept within limits by the vicissitudes of gold mining. Moreover, only a part of the additional gold immediately increased the supply offered on the loan market. The greater part acted first upon commodity prices and wage rates and affected the loan market only at a later stage of the inflationary process.

  However, the continuous increase in the quantity of commodity money exercised a steady expansionist pressure on the loan market. The gross market rate of interest was, in the course of the last centuries, continually subject to the impact of an inflow of additional money into the loan market. Of course, this pressure for the last hundred and fifty years in the Anglo-Saxon countries and for the last hundred years in the countries of the European continent, was far exceeded by the effects of the synchronous development of circulation credit as granted by the banks apart from their—from time to time reiterated—straightforward endeavors to lower the gross market rate of interest by an intensified expansion of credit. Thus three tendencies toward a lowering of the gross market rate of interest were operating at the same time and strengthening one another. One was the outgrowth of the steady increase in the quantity of commodity money, the second the outgrowth of a spontaneous development of fiduciary media in banking operations, the third the fruit of intentional anti-interest policies sponsored by the authorities and approved by public opinion. It is, of course, impossible to ascertain in a quantitative way the effect of their joint operation and the contribution of each of them; an answer to such a question can only be provided by historical understanding.

  What catallactic reasoning can show us is merely that a slight although continuous pressure on the gross market rate of interest as originating from a continuous increase in the quantity of gold, and also from a slight increase in the quantity of fiduciary media, which is not overdone and intensified by purposeful easy money policy, can be counterpoised by the forces of readjustment and accommodation inherent in the market economy. The adaptability of business not purposely sabotaged by forces extraneous to the market is powerful enough to offset the effects which such slight disturbances of the loan market can possibly bring about.

  Statisticians have tried to investigate the long waves of business fluctuations with statistical methods. Such attempts are futile. The history of modern capitalism is a record of steady economic progress, again and again interrupted by feverish booms and their aftermath, depressions. It is generally possible to discern statistically these recurring oscillations from the general trend toward an increase in the amount of capital invested and the quantity of products turned out. It is impossible to discover any rhythmical fluctuation in the general trend itself.

  9. The Market Economy as Affected by the Recurrence of the Trade Cycle

  The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers’ stone to make it last.

  It has been pointed out already in what respect we are free to call an improvement in the quality and an increase in the quantity of products economic progress. If we apply this yardstick to the various phases of the cyclical fluctuations of business, we must call the boom retrogression and the depression progress. The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment. The depression, on the other hand, is the way back to a state of affairs in which all factors of production are employed for the best possible satisfaction of the most urgent needs of the consumers.

  Desperate attempts have been made to find in the boom some positive contribution to economic progress. Stress has been laid upon the role forced saving plays in fostering capital accumulation. The argument is vain. It has been shown already that it is very questionable whether forced saving can ever achieve more than to counterbalance a part of the capital consumption generated by the boom. If those praising the allegedly beneficial effects of forced saving were consistent, they would advocate a fiscal system subsidizing the rich out of taxes collected from people with modest incomes. The forced saving achieved by this method would provide a net increase in the amount of capital available
without simultaneously bringing about capital consumption of a much greater size.

  Advocates of credit expansion have furthermore emphasized that some of the malinvestments made in the boom later become profitable. These investments, they say, were made too early, i.e., at a date when the state of the supply of capital goods and the valuations of the consumers did not yet allow their construction. However, the havoc caused was not too bad, as these projects would have been executed anyway at a later date. It may be admitted that this description is adequate with regard to some instances of malinvestment induced by a boom. But nobody would dare to assert that the statement is correct with regard to all projects whose execution has been encouraged by the illusions created by the easy money policy. However this may be, it cannot influence the consequences of the boom and cannot undo or deaden the ensuing depression. The effects of the malinvestment appear without regard to whether or not these malinvestments will appear as sound investments at a later time under changed conditions. When, in 1845, a railroad was constructed in England which would not have been constructed in the absence of credit expansion, conditions in the following years were not affected by the prospect that in 1870 or 1880 the capital goods required for its construction would be available. ‘Die gain which later resulted from the fact that the railroad concerned did not have to be built by a fresh expenditure of capital and labor, was in 1847 no compensation for the losses incurred by its premature construction.

  The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the necessary collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.