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V: Modern Cyclical Policy - Ludwig von Mises, On the Manipulation of Money and Credit: Three Treatises on Trade-Cycle Theory 
On the Manipulation of Money and Credit: Three Treatises on Trade-Cycle Theory. Translated and with a Foreword by Bettina Bien Greaves,. Edited by Percy L. Greaves, Jr. (Indianapolis: Liberty Fund, 2011).
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Modern Cyclical Policy
Pre–World War I Policy
The cyclical policy recommended today, in most of the literature dealing with the problem of business fluctuations and toward which considerable strides have already been made in the United States, rests entirely on the reasoning of the Circulation Credit Theory.1 The aim of much of this literature is to make this theory useful in practice by studying business conditions with precise statistical methods.
There is no need to explain further that there is only one business cycle theory—the Circulation Credit Theory. All other attempts to cope with the problem have failed to withstand criticism. Every crisis policy and every cyclical policy has been derived from this theory. Its ideas have formed the basis of those cyclical and crisis policies pursued in the decades preceding the war. Thus, the Banking Theory, then recognized in literature as the only correct explanation, as well as all those interpretations which related the problem to the theory of direct exchange, were already disregarded. It may have still been popular to speak of the elasticity of notes in circulation as depending on the discounting of commodity bills of exchange. However, in the world of the bank managers, who made cyclical policy, other views prevailed.
To this extent, therefore, one cannot say that the theory behind today’s cyclical policy is new. The Circulation Credit Theory has, to be sure, come a long way from the old Currency Theory. The studies which Walras, Wicksell and I have devoted to the problem have conceived of it as a more general phenomenon. These studies have related it to the whole economic process. They have sought to deal with it especially as a problem of interest rate formulation and of “equilibrium” on the loan market. To recognize the extent of the progress made, compare, for instance, the famous controversy over free credit between Bastiat and Proudhon.2 Or compare the usual criticism of the Quantity Theory in prewar German literature with recent discussions on the subject. However, no matter how significant this progress may be considered for the development of our understanding, we should not forget that the Currency Theory had already offered policy making every assistance in this regard that a theory can.
It is certainly not to be disputed that substantial progress was made when the problem was considered, not only from the point of view of fiduciary media, but from that of the entire problem of the purchasing power of money. The Currency School paid attention to price changes only insofar as they were produced by an increase or decrease of circulation credit—but they considered only the circulation credit granted by the issue of notes. Thus, the Currency School was a long way from striving for stabilization of the purchasing power of the monetary unit.
Post–World War I Policies
Today these two problems, the issuance of fiduciary media and the purchasing power of the monetary unit, are seen as being closely linked to the Circulation Credit Theory. One of the tendencies of modern cyclical policy is that these two problems are treated as one. Thus, one aim of cyclical policy is no more nor less than the stabilization of the purchasing power of money. For a discussion of this see Part I of this study.
Like the Currency School, the other aim is not to stabilize purchasing power but only to avoid the crisis. However, a still further goal is contemplated—similar to that sought by the Peel Act and by prewar cyclical policy. It is proposed to counteract a boom, whether caused by an expansion of fiduciary media or by a monetary inflation (for example, an increase in the production of gold). Then again, depression is to be avoided when there is restriction irrespective of whether it starts with a contraction in the quantity of money or of fiduciary media. The aim is not to keep prices stable, but to prevent the free market interest rate from being reduced temporarily by the banks of issue or by monetary inflation.
In order to explain the essence of this new policy, we shall now explore two specific cases in more detail:
1. The production of gold increases and prices rise. A price premium appears in the interest rate that would limit the demand for loans to the supply of lendable funds available. The banks, however, have no reason to raise their lending rate. As a matter of fact, they become more willing to discount at a lower rate as the relationship between their obligations and their stock of gold has been improved. It has certainly not deteriorated. The actual loan rate they are asking lags behind the interest rate that would prevail on a free market, thus providing the initiative for a boom. In this instance, prewar crisis policy would not have intervened since it considered only the ratio of the bank’s cover which had not deteriorated. As prices and wages rise [resulting in an increased demand for business loans], modern theory maintains that the interest rates should rise and circulation credit be restricted.
2. The inducement to the boom has been given by the banks in response, let us say, to the general pressure to make credit cheaper in order to combat depression, without any change in the quantity of money in the narrower sense. Since the cover ratio deteriorates as a result, even the older crisis policy would have called for increasing the interest rate as a brake.
Only in the first of these two instances does a fundamental difference exist between old and new policies.
Many now engaged in cyclical research maintain that the special superiority of current crisis policy in America rests on the use of more precise statistical methods than those previously available. Presumably, means for eliminating seasonal fluctuations and the secular general trend have been developed from statistical series and curves. Obviously, it is only with such manipulations that the findings of a market study may become a study of the business cycle. However, even if one should agree with the American investigators in their evaluation of the success of this effort, the question remains as to the usefulness of index numbers. Nothing more can be added to what has been said above on the subject, in Part I of this study.
The development of the Three Market Barometer3 is considered the most important accomplishment of the Harvard investigations. Since it is not possible to determine Wicksell’s natural rate of interest or the “ideal” price premium, we are advised to compare the change in the interest rate with the movement of prices and other data indicative of business conditions, such as production figures, the number of unemployed, etc. This has been done for decades. One need only glance at reports in the daily papers, economic weeklies, monthlies and annuals of the last two generations to discover that the many claims, made so proudly today, of being the first to recognize the significance of such data for understanding the course of business conditions are unwar-ranted. The Harvard institute, however, has performed a service in that it has sought to establish an empirical regularity in the timing of the movements in the three curves.
There is no need to share the exuberant expectations for the practical usefulness of the Harvard barometer which has prevailed in the American business world for some time. It can readily be admitted that this barometer has scarcely contributed anything toward increasing and deepening our knowledge of cyclical movements. Nevertheless, the significance of the Harvard barometer for the investigation of business conditions may still be highly valued, for it does provide statistical substantiation of the Circulation Credit Theory. Twenty years ago, it would not have been thought possible to arrange and manipulate statistical material so as to make it useful for the study of business conditions. Here real success has crowned the ingenious work done by economists and statisticians together.
Upon examining the curves developed by institutes using the Harvard method, it becomes apparent that the movement of the money market curve (C Curve) in relation to the stock market curve (A Curve) and the commodity market curve (B Curve) corresponds exactly to what the Circulation Credit Theory asserts. The fact that the movements of A Curve generally anticipate those of B Curve is explained by the greater sensitivity of stock, as opposed to commodity, speculation. The stock market reacts more promptly than does the commodity market. It sees more and it sees farther. It is quicker to draw coming events (in this case, the changes in the interest rate) into the sphere of its conjectures.
Arbitrary Political Decisions
However, the crucial question still remains: What does the Three Market Barometer offer the man who is actually making bank policy? Are modern methods of studying business conditions better suited than the former, to be sure less thorough, ones for laying the groundwork for decisions on a discount policy aimed at reducing as much as possible the ups and downs of business? Even prewar [World War I] banking policy had this for its goal. There is no doubt that government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses, were frankly and sincerely interested in attaining this goal. Their efforts in this direction—only when the boom was already in full swing to be sure— were supported at least by a segment of public opinion and of the press. They knew well enough what was needed to accomplish the desired effect. They knew that nothing but a timely and sufficiently far-reaching increase in the loan rate could counteract what was usually referred to as “excessive speculation.”
They failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. However, this fact did not prevent them, once the cyclical upswing became obvious, from thinking about its unavoidable outcome. They did not know that the upswing had been generated by the conduct of the banks. If they had, they might well have seen it only as a blessing of banking policy, for to them the most important task of economic policy was to overcome the depression, at least so long as the depression lasted. Still they knew that a progressing upswing must lead to crisis and then to stagnation.
As a result, the trade boom evoked misgivings at once. The immediate problem became simply how to counteract the onward course of the “unhealthy” development. There was no question of “whether,” but only of “how.” Since the method—increasing the interest rate—was already settled, the question of “how” was only a matter of timing and degree: When and how much should the interest rate be raised?
The critical point was that this question could not be answered precisely, on the basis of undisputed data. As a result, the decision must always be left to discretionary judgment. Now, the more firmly convinced those responsible were that their interference, by raising the interest rate, would put an end to the prosperity of the boom, the more cautiously they must act. Might not those voices be correct which maintained that the upswing was not “artificially” produced, that there wasn’t any “overspeculation” at all, that the boom was only the natural outgrowth of technical progress, the development of means of communication, the discovery of new supplies of raw materials, the opening up of new markets? Should this delightful and happy state of affairs be rudely interrupted? Should the government act in such a way that the economic improvement, for which it took credit, gives way to crisis?
The hesitation of officials to intervene is sufficient to explain the situation. To be sure, they had the best of intentions for stopping in time. Even so, the steps they took were usually “too little and too late.” There was always a time lag before the interest rate reached the point at which prices must start down again. In the interim, capital had become frozen in investments for which it would not have been used if the interest rate on money had not been held below its “natural rate.”
This drawback to cyclical policy is not changed in any respect if it is carried out in accordance with the business barometer. No one who has carefully studied the conclusions drawn from observations of business conditions made by institutions working with modern methods will dare to contend that these results may be used to establish, incontrovertibly, when and how much to raise the interest rate in order to end the boom in time before it has led to capital malinvestment. The accomplishment of economic journalism in reporting regularly on business conditions during the last two generations should not be under rated. Nor should the contribution of contemporary business cycle research institutes, working with substantial means, be over rated. Despite all the improvements which the preparation of statistics and graphic interpretations have undergone, their use in the determination of interest rate policy still leaves a wide margin for judgment.
Sound Theory Essential
Moreover, it should not be forgotten that it is impossible to answer in a straightforward manner not only how seasonal variations and growth factors are to be eliminated, but also how to decide unequivocably from what data and by what method the curves of each of the Three Markets should be constructed. Arguments which cannot be easily refuted may be raised on every point with respect to the business barometer. Also, no matter how much the business barometer may help us to survey the many heterogeneous operations of the market and of production, they certainly do not offer a solid basis for weighing contingencies. Business barometers are not even in a position to furnish clear and certain answers to the questions concerning cyclical policy which are crucial for their operation. Thus, the great expectations generally associated with recent cyclical policy today are not justified.
For the future of cyclical policy more profound theoretical knowledge concerning the nature of changes in business conditions would inevitably be of incomparably greater value than any conceivable manipulation of statistical methods. Some business cycle research institutes are imbued with the erroneous idea that they are conducting impartial factual research, free of any prejudice due to theoretical considerations. In fact, all their work rests on the groundwork of the Circulation Credit Theory. In spite of the reluctance which exists today against logical reasoning in economics and against thinking problems and theories through to their ultimate conclusions, a great deal would be gained if it were decided to base cyclical policy deliberately on this theory. Then, one would know that every expansion of circulation credit must be counteracted in order to even out the waves of the business cycle. Then, a force operating on one side to reduce the purchasing power of money would be offset from the other side. The difficulties, due to the impossibility of finding any method for measuring changes in purchasing power, cannot be overcome. It is impossible to realize the ideal of either a monetary unit of unchanging value or economic stability. However, once it is resolved to forego the artificial stimulation of business activity by means of banking policy, fluctuations in business conditions will surely be substantially reduced. To be sure this will mean giving up many a well-loved slogan, for example, “easy money” to encourage credit transactions. However, a still greater ideological sacrifice than that is called for. The desire to reduce the interest rate in any way must also be abandoned.
It has already been pointed out that events would have turned out very differently if there had been no deviation from the principle of complete freedom in banking and if the issue of fiduciary media had been in no way exempted from the rules of commercial law. It may be that a final solution of the problem can be arrived at only through the establishment of completely free banking. However, the credit structure which has been developed by the continued effort of many generations cannot be transformed with one blow. Future generations, who will have recognized the basic absurdity of all interventionist attempts, will have to deal with this question also. However, the time is not yet ripe—not now nor in the immediate future.
[1. ][The United States Federal Reserve System, established in 1913, was intended to limit monetary expansion. It responded to the post–World War I boom by raising the discount rate, bringing an end to credit expansion and precipitating the 1920–1921 correction period, or “recession.”—Ed.]
[2. ][Frédéric Bastiat (1801–1850) replied to an open letter addressed to him by an editor of Voix du Peuple (October 22, 1849). Then the socialist Pierre Jean Proudhon (1809–1865), answered. Proudhon, an advocate of unlimited monetary expansion by reduction of the interest rate to zero, and Bastiat, who favored moderate credit expansion and only a limited reduction of interest rates, carried on a lengthy exchange for several months, until March 7, 1850. (Oeuvres Complètes de Frédéric Bastiat. 4th ed. Vol. 5. Paris, 1878, pp. 93–336.)—Ed.]
[3. ][This Harvard barometer was developed at the university by the Committee on Economic Research from three statistical series which are presumed to reveal (1) the extent of stock speculation, (2) the condition of industry and trade and (3) the supply of funds.—Ed.]