Chapter 12—The Economics of Violent
Intervention in the Market (continued)
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Chapter 12—The
Economics of Violent Intervention in the Market
(continued)
11. Binary
Intervention: Inflation and Business Cycles
A.
Inflation and Credit Expansion
In chapter 11, we depicted the workings of the monetary system of a
purely free market. A free money market adopts specie, either
gold or silver or both parallel, as the “standard”
or money proper. Units of money are simply units
of weight of the money-stuff. The total stock of the money
commodity increases with new production (mining) and decreases from
wear and tear and use in industrial employments. Generally, there will
be a gradual secular rise in the money stock, with effects as analyzed
above. The wealth of some people will increase and of others will
decline, and no social usefulness will accrue from an increased supply
of money—in its monetary use. However, an increased stock
will raise the social standard of living and well-being by further
satisfying nonmonetary demands for the monetary
metal.
Intervention in this money market usually takes the form of issuing
pseudo warehouse receipts as money-substitutes. As we saw in chapter
11, demand liabilities such as deposits or paper notes may come into
use in a free market, but may equal only the actual value, or weight,
of the specie deposited. The demand liabilities are then genuine
warehouse receipts, or true money certificates, and they pass on the
market as representatives of the actual money, i.e., as
money-substitutes. Pseudo warehouse receipts are those issued
in excess of the actual weight of specie on deposit. Naturally, their
issue can be a very lucrative business. Looking like the
genuine certificates, they serve also as money-substitutes, even though
not covered by specie. They are fraudulent, because they promise to
redeem in specie at face value, a promise that could not possibly be
met were all the deposit-holders to ask for their own property
at the same time. Only the complacency and ignorance of the public
permit the situation to continue.
Broadly, such intervention may be effected either by the
government or by private individuals and firms in their role
as “banks” or money-warehouses. The process of
issuing pseudo warehouse receipts or, more exactly, the
process of issuing money beyond any increase in the stock of specie,
may be called inflation.
A contraction in the money
supply outstanding over any period (aside from a possible net decrease
in specie) may be called deflation. Clearly, inflation is
the primary event and the primary purpose of monetary intervention.
There can be no deflation without an inflation having occurred in some
previous period of time. A priori, almost all
intervention will be inflationary. For not only must all monetary
intervention begin with inflation; the great gain
to be derived from inflation comes from the issuer’s putting
new money into circulation. The profit is practically
costless, because, while all other people must either sell
goods and services and buy or mine gold, the government or the
commercial banks are literally creating money out of thin air.
They do not have to buy it. Any profit from the use of this magical
money is clear gain to the issuers.
As happens when new specie enters the market, the issue of
“uncovered” money-substitutes also has a diffusion
effect: the first receivers of the new money gain the most, the next
gain slightly less, etc., until the midpoint is reached, and then each
receiver loses more and more as he waits for the new money. For the
first individuals’ selling prices soar while buying prices
remain almost the same; but later, buying prices have risen while
selling prices remain unchanged. A crucial circumstance, however,
differentiates this from the case of increasing specie. The
new paper or new demand deposits have no social function whatever; they
do not demonstrably benefit some without injuring others in the market
society. The increasing money supply is only a social waste and can
only advantage some at the expense of others. And the benefits and
burdens are distributed as just outlined: the early-comers gaining at
the expense of later-comers. Certainly, the business and consumer
borrowers from the bank—its clientele—benefit
greatly from the new money (at least in the short run), since they are
the ones who first receive it.
If inflation is any increase in the supply of money not
matched by an increase in the gold or silver stock available, the
method of inflation just depicted is called credit expansion—the
creation of new money-substitutes, entering the economy on
the credit market. As will be seen below, while credit
expansion by a bank seems far more sober and
respectable than outright spending of new money, it actually has far
graver consequences for the economic system, consequences
which most people would find especially undesirable. This
inflationary credit is called circulating credit,
as distinguished from the lending of saved funds—called
commodity credit. In this book, the term
“credit expansion” will apply only to increases in
circulating credit.
Credit expansion has, of course, the same effect as any sort of
inflation: prices tend to rise as the money supply increases. Like any
inflation, it is a process of redistribution, whereby the inflators,
and the part of the economy selling to them, gain at the expense of
those who come last in line in the spending process. This is the charm
of inflation—for the beneficiaries—and the
reason why it has been so popular, particularly since modern
banking processes have camouflaged its significance for those
losers who are far removed from banking operations. The gains to the
inflators are visible and dramatic; the losses to others
hidden and unseen, but just as effective for all that. Just as half the
economy are taxpayers and half tax-consumers, so half the economy are
inflation-payers and the rest inflation-consumers.
Most of these gains and losses will be “short-run”
or “one-shot”; they will occur during the process
of inflation, but will cease after the new monetary equilibrium is
reached. The inflators make their gains, but after the new
money supply has been diffused throughout the economy, the inflationary
gains and losses are ended. However, as we have seen in chapter 11,
there are also permanent gains and losses resulting
from inflation. For the new monetary equilibrium will not simply be the
old one multiplied in all relations and quantities by the addition to
the money supply. This was an assumption that the old
“quantity theory” economists made. The valuations
of the individuals making temporary gains and losses will
differ. Therefore, each individual will react differently to his gains
and losses and alter his relative spending patterns accordingly.
Moreover, the new money will form a high ratio to the existing cash
balance of some and a low ratio to that of others, and the result will
be a variety of changes in spending patterns. Therefore, all prices
will not have increased uniformly in the new
equilibrium; the purchasing power of the monetary unit has fallen, but
not equiproportionally over the entire array of exchange-values. Since
some prices have risen more than others, therefore, some people will be
permanent gainers, and some permanent
losers, from the inflation.
Particularly hard hit by an inflation, of course, are the
relatively “fixed” income groups, who end
their losses only after a long period or not at all. Pensioners and
annuitants who have contracted for a fixed money income are examples of
permanent as well as short-run losers. Life insurance benefits are
permanently slashed. Conservative
anti-inflationists’ complaints about “the widows
and orphans” have often been ridiculed, but they are no
laughing matter nevertheless. For it is precisely the widows
and orphans who bear a main part of the brunt of inflation.
Also suffering losses are
creditors who have already extended their loans and find it
too late to charge a purchasing-power premium on their interest rates.
Inflation also changes the market’s consumption/investment
ratio. Superficially, it seems that credit expansion greatly
increases capital, for the new money enters the market as equivalent to
new savings for lending. Since the new “bank money”
is apparently added to the supply of savings on the credit
market, businesses can now borrow at a lower rate of interest;
hence inflationary credit expansion seems to offer the ideal
escape from time preference, as well as an inexhaustible fount of added
capital. Actually, this effect is illusory. On the contrary, inflation
reduces saving and investment, thus lowering society’s
standard of living. It may even cause large-scale capital consumption.
In the first place, as we just have seen, existing creditors are
injured. This will tend to discourage lending in the future and thereby
discourage saving-investment. Secondly, as we have seen in
chapter 11, the inflationary process inherently yields a
purchasing-power profit to the businessman, since he purchases factors
and sells them at a later time when all prices are higher. The
businessman may thus keep abreast of the price increase (we
are here exempting from variations in price
increases the terms-of-trade component), neither losing nor gaining
from the inflation. But business accounting is traditionally geared to
a world where the value of the monetary unit is stable. Capital goods
purchased are entered in the asset column “at
cost,” i.e., at the price paid for them. When the firm later
sells the product, the extra inflationary gain is not really a gain at
all; for it must be absorbed in purchasing the replaced
capital good at a higher price. Inflation, therefore, tricks the
businessman: it destroys one of his main signposts and leads
him to believe that he has gained extra profits when he is just able to
replace capital. Hence, he will undoubtedly be tempted to
consume out of these profits and thereby unwittingly consume
capital as well. Thus, inflation tends at once to repress
saving-investment and to cause consumption of capital.
The accounting error stemming from inflation has other
economic consequences. The firms with the greatest degree of
error will be those with capital equipment bought more
preponderantly when prices were lowest. If the inflation has
been going on for a while, these will be the firms with the oldest
equipment. Their seemingly great profits will attract other firms into
the field, and there will be a completely unjustified expansion of
investment in a seemingly high-profit area. Conversely, there
will be a deficiency of investment elsewhere. Thus, the error distorts
the market’s system of allocating resources and reduces its
effectiveness in satisfying the consumer. The error will also
be greatest in those firms with a greater proportion of capital
equipment to product, and similar distorting effects will take place
through excessive investment in heavily
“capitalized” industries, offset by underinvestment
elsewhere.
B.
Credit Expansion and the Business Cycle
We have already seen in chapter 8 what happens when there is net
saving-investment: an increase in the ratio of gross
investment to consumption in the economy. Consumption
expenditures fall, and the prices of consumers’ goods fall.
On the other hand, the production structure is lengthened, and the
prices of original factors specialized in the higher stages rise. The
prices of capital goods change like a lever being pivoted on a fulcrum
at its center; the prices of consumers’ goods fall
most, those of first-order capital goods fall less; those of
highest-order capital goods rise most, and the others less. Thus, the price
differentials between the stages of production all diminish.
Prices of original factors fall in the lower stages and rise in the
higher stages, and the nonspecific original factors (mainly
labor) shift partly from the lower to the higher stages. Investment
tends to be centered in lengthier processes of production. The drop in
price differentials is, as we have seen, equivalent
to a fall in the natural rate of interest, which, of course, leads to a
corollary drop in the loan rate. After a while the fruit of the more
productive techniques arrives; and the real income of everyone rises.
Thus, an increase in saving resulting from a fall in time
preferences leads to a fall in the interest rate and another
stable equilibrium situation with a longer and narrower production
structure. What happens, however, when the increase in
investment is not due to a change in time
preference and saving, but to credit expansion by the commercial banks?
Is this a magic way of expanding the capital structure easily and
costlessly, without reducing present consumption? Suppose that
six million gold ounces are being invested, and four million consumed,
in a certain period of time. Suppose, now, that the banks in the
economy expand credit and increase the money supply by two
million ounces. What are the consequences? The new money is loaned to
businesses.
These businesses, now able
to acquire the money at a lower rate of interest, enter the capital
goods’ and original factors’ market to bid
resources away from the other firms. At any given time, the stock of
goods is fixed, and the two million new ounces are therefore employed
in raising the prices of producers’ goods. The rise in prices
of capital goods will be imputed to rises in original factors.
The credit expansion reduces the market rate of interest. This means
that price differentials are lowered, and, as we have seen in chapter
8, lower price differentials raise prices in the highest stages of
production, shifting resources to these stages and also increasing the
number of stages. As a result, the production structure is
lengthened. The borrowing firms are led to believe that enough funds
are available to permit them to embark on projects formerly
unprofitable. On the free market, investment will always take place
first in those projects that satisfy the most urgent wants of the
consumers. Then the next most urgent wants are satisfied, etc. The
interest rate regulates the temporal order of choice of projects in
accordance with their urgency. A lower rate of interest on the market
is a signal that more projects can be undertaken profitably. Increased
saving on the free market leads to a stable equilibrium of production
at a lower rate of interest. But not so with credit expansion: for the original
factors now receive increased money income. In the
free-market example, total money incomes remained the same. The
increased expenditure on higher stages was offset by decreased
expenditure in the lower stages. The “increased
length” of the production structure was compensated
by the “reduced width.” But credit
expansion pumps new money into the production structure:
aggregate money incomes increase instead of remaining the same. The
production structure has lengthened, but it has also remained
as wide, without contraction of consumption expenditure.
The owners of the original factors, with their increased money income,
naturally hasten to spend their new money. They allocate this
spending between consumption and investment in accordance with
their time preferences. Let us assume that the time-preference
schedules of the people remain unchanged. This is a proper assumption,
since there is no reason to assume that they have changed because of
the inflation. Production now no longer reflects voluntary time
preferences. Business has been led by credit expansion to invest in
higher stages, as if more savings were available.
Since they are not, business has overinvested in the higher stages and
underinvested in the lower. Consumers act promptly to re-establish
their time preferences—their preferred investment/consumption
proportions and price differentials. The differentials
will be re-established at the old, higher amount, i.e., the rate of
interest will return to its free-market magnitude. As a result, the
prices at the higher stages of production will fall drastically, the
prices at the lower stages will rise again, and the entire new
investment at the higher stages will have to be abandoned or
sacrificed.
Altering our oversimplified example, which has treated only two
stages, we see that the highest stages, believed profitable, have
proved to be unprofitable. The pure rate of interest, reflecting
consumer desires, is shown to have really been
higher all along. The banks’ credit expansion had tampered
with that indispensable
“signal”—the interest rate—that
tells businessmen how much savings are available and what length of
projects will be profitable. In the free market the interest
rate is an indispensable guide, in the time dimension, to the urgency
of consumer wants. But bank intervention in the market disrupts this
free price and renders entrepreneurs unable to satisfy consumer desires
properly or to estimate the most beneficial time structure of
production. As soon as the consumers are able, i.e., as soon as the
increased money enters their hands, they take the opportunity to
re-establish their time preferences and therefore the old
differentials and investment-consumption ratios. Overinvestment
in the highest stages, and underinvestment in the
lower stages are now revealed in all their starkness. The situation is
analogous to that of a contractor misled into believing that
he has more building material than he really has and then awakening to
find that he has used up all his material on a capacious foundation
(the higher stages), with no material left to complete the house.
Clearly, bank credit
expansion cannot increase capital investment by one iota. Investment
can still come only from savings.
It should not be surprising that the market tends to revert to its
preferred ratios. The same process, as we have seen, takes place in all
prices after a change in the money stock. Increased money always begins
in one area of the economy, raising prices there, and filters and
diffuses eventually over the whole economy, which then roughly returns
to an equilibrium pattern conforming to the value of the money. If the
market then tends to return to its preferred price-ratios after a
change in the money supply, it should be evident that this includes
a return to its preferred saving-investment ratio, reflecting
social time preferences.
It is true, of course, that time preferences may alter in the interim,
either for each individual or as a result of the
redistribution during the change. The gainers may save more or
less than the losers would have done. Therefore, the market will not
return precisely to the old free-market interest rate and
investment/consumption ratio, just as it will not return to
its precise pattern of prices. It will revert to whatever the
free-market interest rate is now, as
determined by current time preferences. Some advocates of coercing the
market into saving and investing more than it wishes have hailed credit
expansion as leading to “forced saving,” thereby
increasing the capital-goods structure. But this can happen, not
as a direct consequence of credit expansion, but only because
effective time preferences have changed in that direction (i.e.,
time-preference schedules have shifted, or relatively more money is now
in the hands of those with low time preferences). Credit expansion may
well lead to the opposite effect: the gainers may have higher
time preferences, in which case the free-market interest rate will be
higher than before. Because these effects of credit expansion
are completely uncertain and depend on the concrete data of each
particular case, it is clearly far more cogent for advocates of forced
saving to use the taxation process to make their
redistribution.
The market therefore reacts to a distortion of the free-market interest
rate by proceeding to revert to that very rate. The distortion
caused by credit expansion deceives businessmen into believing
that more savings are available and causes them to malinvest—to
invest in projects that will turn out to be unprofitable when consumers
have a chance to reassert their true preferences. This reassertion
takes place fairly quickly—as soon as owners of factors
receive their increased incomes and spend them.
This theory permits us to resolve an age-old controversy among
economists: whether an increase in the money supply can lower the
market rate of interest. To the mercantilists—and to the
Keynesians—it was obvious that an increased money stock
permanently lowered the rate of interest (given the demand for
money). To the classicists it was obvious that changes in the money
stock could affect only the value of the monetary unit, and not the
rate of interest. The answer is that an increase in the supply of money
does lower the rate of interest when it
enters the market as credit expansion, but only temporarily.
In the long run (and this long run is not very
“long”), the market re-establishes the
free-market time-preference interest rate and eliminates the
change. In the long run a change in the money stock affects only the
value of the monetary unit.
This process—by which the market reverts to its preferred
interest rate and eliminates the distortion caused by credit
expansion—is, moreover, the
business cycle! Our analysis therefore permits the
solution, not only of the theoretical problem of the relation
between money and interest, but also of the problem that has plagued
society for the last century and a half and more—the dread
business cycle. And, furthermore, the theory of the business
cycle can now be explained as a subdivision of our general theory of
the economy.
Note the hallmarks of this distortion-reversion process. First, the
money supply increases through credit expansion; then
businesses are tempted to malinvest—overinvesting in
higher-stage and durable production processes. Next, the prices and
incomes of original factors increase and consumption increases, and
businesses realize that the higher-stage investments have been
wasteful and unprofitable. The first stage is the chief
landmark of the “boom”; the second
stage—the discovery of the wasteful
malinvestments—is the “crisis.”
The depression is the next stage, during
which malinvested businesses become bankrupt, and original factors must
suddenly shift back to the lower stages of production. The
liquidation of unsound businesses, the “idle
capacity” of the malinvested plant, and the
“frictional” unemployment of original factors that
must suddenly and en masse shift to lower stages of
production—these are the chief hallmarks of the
depression stage.
We have seen in chapter 11 that the major unexplained features
of the business cycle are the mass of error and the
concentration of error and disturbance in the capital-goods
industries. Our theory of the business cycle solves both of these
problems. The cluster of error suddenly revealed by entrepreneurs is
due to the interventionary distortion of a key market
signal—the interest rate. The concentration of
disturbance in the capital-goods industries is explained by the spur to
unprofitable higher-order investments in the boom period. And we have
just seen that other characteristics of the business cycle are
explained by this theory.
One point should be stressed: the depression phase
is actually the recovery phase. Most people would
be happy to keep the boom period, where the inflationary gains are
visible and the losses hidden and obscure. This boom euphoria
is heightened by the capital consumption that inflation
promotes through illusory accounting profits. The stages that
people complain about are the crisis and depression. But the latter
periods, it should be clear, do not cause the trouble. The trouble
occurs during the boom, when malinvestments and distortions take place;
the crisis-depression phase is the curative period, after people have
been forced to recognize the malinvestments that have
occurred. The depression period, therefore, is the
necessary recovery period; it is the time when bad investments are
liquidated and mistaken entrepreneurs leave the market—the
time when “consumer sovereignty” and the free
market reassert themselves and establish once again an economy
that benefits every participant to the maximum degree. The depression
period ends when the free-market equilibrium has been restored and
expansionary distortion eliminated.
It should be clear that any governmental interference with the
depression process can only prolong it, thus making things worse from
almost everyone’s point of view. Since the depression process
is the recovery process, any halting or slowing down
of the process impedes the advent of recovery. The depression
readjustments must work themselves out before recovery can be complete.
The more these readjustments are delayed, the longer the depression
will have to last, and the longer complete recovery is postponed. For
example, if the government keeps wage rates up, it brings about
permanent unemployment. If it keeps prices up, it brings about unsold
surplus. And if it spurs credit expansion again, then new malinvestment
and later depressions are spawned.
Many nineteenth-century economists referred to the business cycle in a
biological metaphor, likening the depression to a painful but
necessary curative of the alcoholic or narcotic jag which is the boom,
and asserting that any tampering with the depression delays
recovery. They have been widely ridiculed by present-day economists.
The ridicule is misdirected, however, for the biological
analogy is in this case correct.
One obvious conclusion from our analysis is the absurdity of the
“underconsumptionist” remedies for
depression—the idea that the crisis is caused by
underconsumption and that the way to cure the depression is to
stimulate consumption expenditures. The reverse is clearly the
truth. What has brought about the crisis is precisely the fact that
entrepreneurial investment erroneously anticipated greater
savings, and that this error is revealed by
consumers’ re-establishing their desired proportion
of consumption. “Overconsumption” or
“undersaving” has brought about the
crisis, although it is hardly fair to pin the guilt on the
consumer, who is simply trying to restore his preferences after the
market has been distorted by bank credit. The only way to hasten the
curative process of the depression is for people to save and invest more
and consume less, thereby finally justifying some
of the malinvestments and mitigating the adjustments that have
to be made.
One problem has been left unexplained. We have seen that the reversion
period is short and that factor incomes increase rather quickly and
start restoring the free-market consumption/saving ratios. But why do
booms, historically, continue for several years? What delays the
reversion process? The answer is that as the boom begins to peter out
from an injection of credit expansion, the banks inject a further dose.
In short, the only way to avert the onset of the
depression-adjustment process is to continue inflating money and
credit. For only continual doses of new money on the credit market will
keep the boom going and the new stages profitable.
Furthermore, only ever increasing doses can step up
the boom, can lower interest rates further, and expand the
production structure, for as the prices rise, more and more
money will be needed to perform the same amount of work. Once the
credit expansion stops, the market ratios are re-established, and the
seemingly glorious new investments turn out to be
malinvestments, built on a foundation of sand.
How long booms can be kept up, what limits there are to booms in
different circumstances, will be discussed below. But it is clear that
prolonging the boom by ever larger doses of credit expansion
will have only one result: to make the inevitably ensuing depression
longer and more grueling. The larger the scope of
malinvestment and error in the boom, the greater and longer
the task of readjustment in the depression. The way to prevent a
depression, then, is simple: avoid starting a boom. And to
avoid starting a boom all that is necessary is to pursue a truly
free-market policy in money, i.e., a policy of 100-percent
specie reserves for banks and governments.
Credit expansion always generates the business cycle process, even when
other tendencies cloak its workings. Thus, many people believe
that all is well if prices do not rise or if the actually recorded
interest rate does not fall. But prices may well not rise because of
some counteracting force—such as an increase in the supply of
goods or a rise in the demand for money. But this does not mean that
the boom-depression cycle fails to occur. The essential
processes of the boom—distorted interest rates,
malinvestments, bankruptcies, etc.—continue
unchecked. This is one of the reasons why those who approach business
cycles from a statistical point of view and try in that way to arrive
at a theory are in hopeless error. Any historical-statistical fact is a
complex resultant of many causal influences and cannot be used as a
simple element with which to construct a causal theory. The point is
that credit expansion raises prices beyond what they would
have been in the free market and thereby creates the business
cycle. Similarly, credit expansion does not necessarily lower the
interest rate below the rate previously
recorded; it lowers the rate below what it would have been in
the free market and thus creates distortion and
malinvestment. Recorded interest rates in the boom will generally rise,
in fact, because of the purchasing-power component
in the market interest rate. An increase in prices, as we have seen,
generates a positive purchasing-power component in the natural interest
rate, i.e., the rate of return earned by businessmen on the market. In
the free market this would quickly be reflected in the loan rate,
which, as we have seen above, is completely dependent on the
natural rate. But a continual influx of circulating credit prevents
the loan rate from catching up with the natural rate, and
thereby generates the business-cycle process.
A further corollary of
this bank-created discrepancy between the loan rate and the natural
rate is that creditors on the loan market suffer losses for
the benefit of their debtors: the capitalists on the stock market or
those who own their own businesses. The latter gain during the boom by
the differential between the loan rate and the natural rate, while the
creditors (apart from banks, which create their own money) lose to the
same extent.
After the boom period is over, what is to be done with the
malinvestments? The answer depends on their profitability for further
use, i.e., on the degree of error that was committed. Some
malinvestments will have to be abandoned, since their earnings from
consumer demand will not even cover the current costs of their
operation. Others, though monuments of failure, will be able to yield a
profit over current costs, although it will not pay to replace them as
they wear out. Temporarily working them fulfills the economic
principle of always making the best of even a bad bargain.
Because of the malinvestments, however, the boom always leads to
general impoverishment, i.e., reduces the standard
of living below what it would have been in the absence of the
boom. For the credit expansion has caused the squandering of scarce
resources and scarce capital. Some resources have been completely
wasted, and even those malinvestments that continue in use will satisfy
consumers less than would have been the case without the credit
expansion.
C.
Secondary Developments of the Business Cycle
In the previous section we have presented the basic process of the
business cycle. This process is often accentuated by other or
“secondary” developments induced by the cycle.
Thus, the expanding money supply and rising prices are likely
to lower the demand for money. Many people begin to anticipate higher
prices and will therefore dishoard. The lowered demand for money raises
prices further. Since the impetus to expansion comes first in
expenditure on capital goods and later in consumption, this
“secondary effect” of a lower demand for
money may take hold first in producers’-goods industries.
This lowers the price-and-profit differentials further and hence widens
the distance that the rate of interest will fall below the free-market
rate during the boom. The effect is to aggravate the need for
readjustment during the depression. The adjustment would cause some
fall in the prices of producers’ goods anyway, since the
essence of the adjustment is to raise price differentials. The extra
distortion requires a steeper fall in the prices of
producers’ goods before recovery is completed.
As a matter of fact, the demand for money generally rises
at the beginning of an inflation. People are accustomed to thinking of
the value of the monetary unit as inviolate and of prices as remaining
at some “customary” level. Hence, when prices first
begin to rise, most people believe this to be a purely
temporary development, with prices soon due to recede. This
belief mitigates the extent of the price rise for a time. Eventually,
however, people realize that credit expansion has continued
and undoubtedly will continue, and their demand for money dwindles,
becoming lower than the original level.
After the crisis arrives and the depression begins, various
secondary developments often occur. In particular, for reasons
that will be discussed further below, the crisis is often marked not
only by a halt to credit expansion, but by an
actual deflation—a contraction in the
supply of money. The deflation causes a further decline in
prices. Any increase in the demand for money will speed up adjustment
to the lower prices. Furthermore, when deflation takes place first on
the loan market, i.e., as credit contraction
by the banks—and this is almost always the
case—this will have the beneficial effect of speeding up the
depression-adjustment process. For credit contraction creates
higher price differentials. And the essence of the required
adjustment is to return to higher price differentials, i.e., a higher
“natural” rate of interest. Furthermore,
deflation will hasten adjustment in yet another way: for the
accounting error of inflation is here reversed, and businessmen will
think their losses are more, and profits less, than they really are.
Hence, they will save more than they would have with correct
accounting, and the increased saving will speed adjustment by supplying
some of the needed deficiency of savings.
It may well be true that the deflationary process will overshoot the
free-market equilibrium point and raise price differentials and the
interest rate above it. But if so, no harm will be done, since a credit
contraction can create no malinvestments and therefore does
not generate another boom-bust cycle.
And the market
will correct the error rapidly. When there is such excessive
contraction, and consumption is too high in relation to savings, the
money income of businessmen is reduced, and their spending on factors
declines—especially in the higher orders. Owners of original
factors, receiving lower incomes, will spend less on
consumption, price differentials and the interest rate will
again be lowered, and the free-market consumption/ investment ratios
will be speedily restored.
Just as inflation is generally popular for its narcotic effect,
deflation is always highly unpopular for the opposite reason.
The contraction of money is visible; the benefits to those whose
buying prices fall first and who lose money last remain
hidden. And the illusory accounting losses of deflation make businesses
believe that their losses are greater, or profits smaller, than they
actually are, and this will aggravate business pessimism.
It is true that deflation takes from one group and gives to
another, as does inflation. Yet not only does credit
contraction speed recovery and counteract the distortions of the boom,
but it also, in a broad sense, takes away from the original coercive
gainers and benefits the original coerced losers. While this will
certainly not be true in every case, in the broad sense much the same
groups will benefit and lose, but in reverse order from that of the
redistributive effects of credit expansion. Fixed-income groups, widows
and orphans, will gain, and businesses and owners of original
factors previously reaping gains from inflation will lose. The longer
the inflation has continued, of course, the less the same individuals
will be compensated.
Some may object that deflation “causes”
unemployment. However, as we have seen above, deflation can
lead to continuing unemployment only if the government or the
unions keep wage rates above the discounted marginal value products of
labor. If wage rates are allowed to fall freely, no continuing
unemployment will occur.
Finally, deflationary credit contraction is, necessarily, severely
limited. Whereas credit can expand (barring various economic limits to
be discussed below) virtually to infinity, circulating credit can
contract only as far down as the total amount of specie in circulation.
In short, its maximum possible limit is the eradication of all
previous credit expansion.
The business-cycle analysis set forth here has essentially been that of
the “Austrian” School, originated and developed by
Ludwig von Mises and some of his students.
A prominent criticism of
this theory is that it “assumes the existence of full
employment” or that its analysis holds only after “full
employment” has been attained. Before that point, say the
critics, credit expansion will beneficently put these factors to work
and not generate further malinvestments or cycles. But, in the
first place, inflation will put no unemployed factors to work unless
their owners, though holding out for a money price higher than their
marginal value product, are blindly content to accept the
necessarily lower real price when it is camouflaged as a rise in the
“cost of living.” And credit expansion generates
further cycles whether or not there are unemployed factors. It creates
more distortions and malinvestments, delays indefinitely the process of
recovery from the previous boom, and makes necessary an eventually far
more grueling recovery to adjust to the new malinvestments as well as
to the old. If idle capital goods are now set to work, this
“idle capacity” is the hangover effect of previous
wasteful malinvestments, and hence is really submarginal and
not worth bringing into production. Putting the capital to work again
will only redouble the distortions.
D.
The Limits of Credit Expansion
Having investigated the consequences of credit expansion, we must
discuss the important question: If fractional-reserve banking is legal,
are there any natural limits to credit expansion by
the banks? The one basic limit, of course, is the necessity of the
banks to redeem their money-substitutes on demand. Under a gold or
silver standard, they must redeem in specie; under a government fiat
paper standard (see below), the banks have to redeem in government
paper. In any case, they must redeem in standard money or its virtual
equivalent. Therefore, every fractional reserve bank depends
for its very existence on persuading the public—specifically
its clients—that all is well and that it
will be able to redeem its notes or deposits whenever the clients
demand. Since this is palpably not the case, the continuance
of confidence in the banks is something of a psychological
marvel.
It is certain, at any
rate, that a wider knowledge of praxeology among the public would
greatly weaken confidence in the banking system. For the banks
are in an inherently weak position. Let just a few of their clients
lose confidence and begin to call on the banks for redemption, and this
will precipitate a scramble by other clients to make sure that they get
their money while the banks’ doors are still open. The
obvious—and justifiable—panic of the banks should
any sort of “run” develop encourages other clients
to do the same and aggravates the run still further. At any rate, runs
on banks can wreak havoc, and, of course, if pursued consistently,
could close every bank in the country in a few days.
Runs, therefore, and the constant underlying threat of their
occurrence, are one of the prime limits to credit expansion.
Runs often develop during a business cycle crisis, when debts are
being defaulted and failures become manifest. Runs and the
fear of runs help to precipitate deflationary credit contraction.
Runs may be an ever-present threat, but, as effective
limitations, they are not generally active. When they do
occur, they usually wreck the banks. The fact that a bank is in
existence at all signifies that a run has not developed. A more active,
everyday limitation is the relatively narrow range
of a bank’s clientele. The clientele of a bank consists of
those people willing to hold its deposits or notes (its
money-substitutes) in lieu of money proper. It is an empirical fact, in
almost all cases, that one bank does not have the patronage of all
people in the market society or even of all those who prefer to use
bank money rather than specie. It is obvious that the more banks exist,
the more restricted will be the clientele of any one bank. People
decide which bank to use on many grounds; reputation for integrity,
friendliness of service, price of service, and convenience of location
may all play a part.
How does the narrow range of a bank’s clientele limit its
potentiality for credit expansion? The newly issued
money-substitutes are, of course, loaned to a bank’s
clients. The client then spends the new money on goods and services.
The new money begins to be diffused throughout the society.
Eventually—usually very quickly—it is spent on the
goods or services of people who use a different
bank. Suppose that the Star Bank has expanded credit; the newly issued
Star Bank’s notes or deposits find their way into the hands
of Mr. Jones, who uses the City Bank. Two alternatives may occur,
either of which has the same economic effect: (a)
Jones accepts the Star Bank’s notes or deposits, and
deposits them in the City Bank, which calls on the Star Bank
for redemption; or (b) Jones refuses to accept the
Star Bank’s notes and insists that the Star
client—say Mr. Smith—who bought something
from Jones, redeem the note himself and pay Jones in
acceptable standard money.
Thus, while gold or silver is acceptable throughout the
market, a bank’s money-substitutes are acceptable
only to its own clientele. Clearly, a single bank’s credit
expansion is limited, and this limitation is stronger (a)
the narrower the range of its clientele, and (b)
the greater its issue of money-substitutes in relation to that
of competing banks. In illustration of the first point, let us assume
that each bank has only one client. Then it is obvious that
there will be very little room for credit expansion. At the opposite
extreme, if one bank is used by everybody in the economy, there will be
no demands for redemption resulting from its clients’
purchasing from nonclients. It is obvious that, ceteris
paribus, a numerically smaller clientele is more restrictive
of credit expansion.
As regards the second point, the greater the degree of relative credit
expansion by any one bank, the sooner will the day of
redemption—and potential bankruptcy—be at
hand. Suppose that the Star Bank expands credit, while none of the
competing banks do. This means that the Star Bank’s clientele
have added considerably to their cash balances; as a result
the marginal utility to them of each unit of money to hold declines,
and they are impelled to spend a great proportion of the new
money. Some of this increased spending will be on one
another’s goods and services, but it is clear that
the greater the credit expansion, the greater will be the tendency for
their spending to “spill over” onto the goods and
services of nonclients. This tendency to spill over, or
“drain,” is greatly enhanced when increased
spending by clients on the goods and services of other clients raises
their prices. In the meanwhile, the prices of the goods sold by
nonclients remain the same. As a consequence, clients are
impelled to buy more from nonclients and less from one another; while
nonclients buy less from clients and more from one another.
The result is an “unfavorable” balance of
trade from clients to nonclients. It is clear that this
tendency of money to seek a uniform level of exchange value throughout
the entire market is an example of the process by which new
money (in this case, new money-substitutes) is diffused through the
market. The greater the relative credit expansion by the bank, then,
the greater and more rapid will be the drain and consequent pressure on
an expanding bank for redemption.
The purpose of banks’ keeping any specie reserves in their
vaults (assuming no legal reserve requirements) now becomes manifest.
It is not to meet bank runs—since no fractional-reserve bank
can be equipped to withstand a run. It is to meet the demands
for redemption which will inevitably come from nonclients.
Mises has brilliantly shown that a subdivision of this process was
discovered by the British Currency School and by the classical
“international trade” theorists of the nineteenth
century. These older economists assumed that all the banks in a certain
region or country expanded credit together. The result was a rise in
the prices of goods produced in that country. A further result
was an “unfavorable” balance of trade, i.e., an
outflow of standard specie to other countries. Since other countries
did not patronize the expanding country’s banks, the
consequence was a “specie drain” from the expanding
country and increased pressure for redemption on its banks.
Like all parts of the overstressed and overelaborated theory of
“international trade,” this analysis is simply a
special subdivision of “general” economic theory.
And cataloging it as “international trade” theory,
as Mises has shown, underestimates its true significance.
Thus, the more freely competitive and numerous are the banks, the less
they will be able to expand fiduciary media, even if they are left free
to do so. As we have noted in chapter 11, such a system is known as
“free banking.”
A major objection to this
analysis of free banking has been the problem of bank
“cartels.” If banks get together and agree to
expand their credits simultaneously, the clientele limitation
vis-à-vis competing banks will be removed, and the clientele
of each bank will, in effect, increase to include all bank users. Mises
points out, however, that the sounder banks with higher fractional
reserves will not wish to lose the goodwill of their own clients and
risk bank runs by entering into collusive agreements with
weaker banks.
This
consideration, while placing limits on such agreements, does
not rule them out altogether. For, after all, no fractional-reserve
banks are really sound, and if the public
can be led to believe that, say, an 80-percent-specie reserve is sound,
it can believe the same about 60-percent- or even 10-percent-reserve
banks. Indeed, the fact that the weaker banks are allowed by the public
to exist at all demonstrates that the more conservative banks may not
lose much good will by agreeing to expand with them.
As Mises has demonstrated, there is no question that, from the point of
view of opponents of inflation and credit expansion, free banking is
superior to a central banking system (see below). But, as Amasa Walker
stated:
Much
has been said, at different times, of the desirableness of free
banking. Of the propriety and rightfulness of allowing any
person who chooses to carry on banking, as freely as farming or any
other branch of business, there can be no doubt. But, while banking, as
at present, means the issuing of inconvertible paper, the more it is
guarded and restricted the better. But when such issues are entirely
forbidden, and only notes equivalent to certificates of so much coin
are issued, banking may be as free as brokerage. The only thing to be
secured would be that no issues should be made except upon specie in
hand.
Although it has obvious
third-person effects, this type of intervention is essentially binary
because the issuer, or intervener, gains at the expense of
individual holders of legitimate money. The “lines of
force” radiate from the interveners to each of those who
suffer losses.
Inflation, in this work, is
explicitly defined to exclude increases in the stock of specie. While
these increases have such similar effects as raising the
prices of goods, they also differ sharply in other effects: (a)
simple increases in specie do not constitute an intervention in the
free market, penalizing one group and subsidizing another; and (b)
they do not lead to the processes of the business cycle.
Cf. Mises, Theory of
Money and Credit, pp. 140–42.
The avowed goal of
Keynes’ inflationist program was the “euthanasia of
the rentier.” Did Keynes realize that he was advocating the
not-so-merciful annihilation of some of the most
unfit-for-labor groups in the entire population—groups whose
marginal value productivity consisted almost exclusively in their
savings? Keynes, General Theory, p. 376.
For an interesting discussion of
some aspects of the accounting error, see W.T.
Baxter, “The Accountant’s Contribution to the Trade
Cycle,” Economica, May, 1955,
pp. 99–112. Also see Mises, Theory
of Money and Credit, pp. 202–04; and Human
Action, pp. 546f.
To the extent that the new money
is loaned to consumers rather than businesses, the
cycle effects discussed in this section do not occur.
See Mises,
Human Action, p. 557.
Since Knut Wicksell is one of the
fathers of this business-cycle approach, it is important to stress that
our usage of “natural rate” differs from his.
Wicksell’s “natural rate” was akin to our
“free-market rate”; our “natural
rate” is the rate of return earned by businesses on the
existing market without considering loan interest. It
corresponds to what has been misleadingly called the “normal
profit rate,” but is actually the basic rate of interest. See
chapter 6 above.
If some readers are tempted to ask
why credit contraction will not lead to the opposite type of
malinvestment to that of the boom—overinvestment in
lower-order capital goods and underinvestment in higher-order
goods—the answer is that there is no arbitrary choice open of
investing in higher-order or lower-order goods. Increased investment must
be made in the higher-order goods—in lengthening the
structure of production. A decreased amount of investment simply cuts
down on higher-order investment. There will thus be no excess
of investment in the lower orders, but simply a shorter
structure than would otherwise be the case. Contraction, unlike
expansion, does not create positive malinvestments.
If the economy is on a gold or
silver standard, then many advocates of a free market will argue for
credit contraction for the following additional reasons: (a)
to preserve the principle of paying one’s contractual
obligations and (b) to punish the banks for their
expansion and force them back toward a 100-percent-specie reserve
policy.
Mises first presented the
“Austrian theory” in a notable section of his Theory
of Money and Credit, pp. 346–66. For a more
developed statement, see his Human Action, pp.
547–83. For F.A. Hayek’s important contributions,
see especially his Prices and Production, and also
his Monetary Theory and the Trade Cycle (London:
Jonathan Cape, 1933), and Profits, Interest, and Investment.
Other works in the Misesian tradition include Robbins, The
Great Depression, and Fritz Machlup, The Stock
Market, Credit, and Capital Formation (New York: Macmillan
& Co., 1940).
See Mises,
Human Action, pp. 577–78; and Hayek, Prices
and Production, pp. 96–99.
Perhaps one reason for continuing
confidence in the banking system is that people generally believe that
fraud is prosecuted by the government and that, therefore, any practice
not so prosecuted must be sound. Governments, indeed
(as we shall see below), always go out of their way to bolster the
banking system.
All this, of course, assumes no
further government intervention in banking than permitting
fractional-reserve banking. Since the advent of deposit
“insurance” during the New Deal, for example, the
bank-run limitation has been virtually eliminated by this act
of special privilege.
In the consolidated balance of
payments of the clients, money income from sales to nonclients
(exports) will decline, and money expenditures on the goods and
services of nonclients (imports) will increase. The excess cash
balances of the clients are transferred to nonclients.
Older economists also
distinguished an “internal drain” as well as the
“external drain,” but included in the former only
the drain from bank users to those who insist on standard money.
See Human Action,
pp. 434–35.
For various views on free and
central banking, see Vera C. Smith, The
Rationale of Central Banking (London: P.S. King and Son,
1936).
Human Action, p. 444.
Amasa Walker, Science of
Wealth, pp. 230–31.
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