The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword
• On the Manipulation of Money and Credit Three Treatises On Trade-cycle Theory
• Stabilization of the Monetary Unit— From the Viewpoint of Theory
• Introduction *
• I: The Outcome of Inflation
• II: The Emancipation of Monetary Value From the Influence of Government
• III: The Return to Gold
• IV: The Money Relation
• V: Comments On the “balance of Payments” Doctrine
• VI: The Inflationist Argument
• VII: The New Monetary System
• VIII: The Ideological Meaning of Reform
• Appendix: Balance of Payments and Foreign Exchange Rates *
• Monetary Stabilization and Cyclical Policy
• Preface *
• Part I: Stabilization of the Purchasing Power of the Monetary Unit
• I: The Problem
• II: The Gold Standard
• III: The “manipulation” of the Gold Standard
• IV: “measuring” Changes In the Purchasing Power of the Monetary Unit
• V: Fisher’s Stabilization Plan
• VI: Goods-induced and Cash-induced Changes In the Purchasing Power of the Monetary Unit
• VII: The Goal of Monetary Policy
• Part II: Cyclical Policy to Eliminate Economic Fluctuations
• I: Stabilization of the Purchasing Power of the Monetary Unit and Elimination of the Trade Cycle
• II: Circulation Credit Theory
• III: The Reappearance of Cycles
• IV: The Crisis Policy of the Currency School
• V: Modern Cyclical Policy
• VI: Control of the Money Market
• VII: Business Forecasting For Cyclical Policy and the Businessman
• VIII: The Aims and Method of Cyclical Policy
• The Causes of the Economic Crisis an Address
• I: The Nature and Role of the Market
• II: Cyclical Changes In Business Conditions
• III: The Present Crisis
• A.: Unemployment
• B.: Price Declines and Price Supports
• C.: Tax Policy
• D.: Gold Production
• IV: Is There a Way Out?
• The Current Status of Business Cycle Research and Its Prospects For the Immediate Future
• 1.: The Acceptance of the Circulation Credit Theory of Business Cycles *
• 2.: The Popularity of Low Interest Rates
• 3.: The Popularity of Labor Union Policy
• 4.: The Effect of Lower Than Unhampered Market Interest Rates
• 5.: The Questionable Fear of Declining Prices
• The Trade Cycle and Credit Expansion: the Economic Consequences of Cheap Money
• 1.: Introductory Remarks *
• 2.: The Unpopularity of Interest
• 3.: The Two Classes of Credit
• 4.: The Function of Prices, Wage Rates and Interest Rates
• 5.: The Effects of Politically Lowered Interest Rates
• 6.: The Inevitable Ending

VIII

The Aims and Method of Cyclical Policy

1.

Revised Currency School Theory

Without doubt, expanding the sphere of scientific investigation from the narrow problem of the crisis into the broader problem of the cycle represents progress.1 However, it was certainly not equally advantageous for political policies. Their scope was broadened. They began to aspire to more than was feasible.

The economy could be organized so as to eliminate cyclical changes only if (1) there were something more than muddled thinking behind the concept that changes in the value of the monetary unit can be measured, and (2) it were possible to determine in advance the extent of the effect which accompanies a definite change in the quantity of money and fiduciary media. As these conditions do not prevail, the goals of cyclical policy must be more limited. However, even if only such severe shocks as those experienced in 1857, 1873, 1900/01 and 1907 could be avoided in the future, a great deal would have been accomplished.

The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency School, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media. However, this does not mean a return to the old Currency School program, the application of which was limited to banknotes. Rather it means the introduction of a new program based on the old Currency School theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits.

The banks would be obliged at all times to maintain metallic backing for all notes—except for the sum of those outstanding which are not now covered by metal—equal to the total sum of the notes issued and bank deposits opened. That would mean a complete reorganization of central bank legislation. The banks of issue would have to return to the principles of Peel’s Bank Act, but with the provisions expanded to cover also bank balances subject to check. The same stipulations with respect to reserves must also be applied to the large national deposit institutions, especially the postal savings.2 Of course, for these secondary banks of issue, the central bank reserves for their notes and deposits would be the equivalent of gold reserves. In those countries where checking accounts at private commercial banks play an important role in trade—notably the United States and England—the same obligation must be exacted from those banks also.

By this act alone, cyclical policy would be directed in earnest toward the elimination of crises.

2.

“Price Level” Stabilization

Under present circumstances, it is out of the question, in the foreseeable future, to establish complete “free banking” and place all banking transactions, including the granting of credit, under ordinary commercial law. Those who speak and write today on behalf of “stabilization,” “maintenance of purchasing power” and “elimination of the trade cycle” can certainly not call this more limited approach “extreme.” On the contrary! They will reject this suggestion as not going far enough. They are demanding much more. In their view, the “price level” should be maintained by countering rising prices with a restriction in the circulation of fiduciary media and, similarly, countering falling prices by the expansion of fiduciary media.

The arguments that may be advanced in favor of this modest program have already been set forth above in the first part of this work. In our judgment, the arguments which militate against all monetary manipulation are so great that placing decisions as to the formation of purchasing power in the hands of banking officials, parliaments and governments, thus making it subject to shifting political influences, must be avoided. The methods available for measuring changes in purchasing power are necessarily defective. The effect of the various maneuvers, intended to influence purchasing power, cannot be quantitatively established—neither in advance nor even after they have taken place. Thus proposals which amount only to making approximate adjustments in purchasing power must be considered completely impractical.

Nothing more will be said here concerning the fundamental absurdity of the concept of “stable purchasing power” in a changing economy. This has already been discussed at some length. For practical economic policy, the only problem is what inflationist or restrictionist measures to consider for the partial adjustment of severe price declines or increases. Such measures, carried out in stages, step by step, through piecemeal international agreements, would benefit either creditors or debtors. However, one question remains: Whether, in view of the conflicts among interests, agreements on this issue could be reached among nations. The viewpoints of creditors and debtors will no doubt differ widely, and these conflicts of interest will complicate still more the manipulation of money internationally than on the national level.

3.

International Complications

It is also possible to consider monetary manipulation as an aspect of national economic policy, and take steps to regulate the value of money independently, without reference to the international situation. According to Keynes,3 if there is a choice between stabilization of prices and stabilization of the foreign exchange rate, the decision should be in favor of price stabilization and against stabilization of the rate of exchange. However, a nation which chose to proceed in this way would create international complications because of the repercussions its policy would have on the content of contractual obligations.

For example, if the United States were to raise the purchasing power of the dollar over that of its present gold parity, the interests of foreigners who owed dollars would be very definitely affected as a result. Then again, if debtor nations were to try to depress the purchasing power of their monetary unit, the interests of creditors would be impaired. Irrespective of this, every change in value of a monetary unit would unleash influences on foreign trade. A rise in its value would foster increased imports, while a fall in its value would be recognized as the power to increase exports.

In recent generations, consideration of these factors has led to pressure for a single monetary standard based on gold. If this situation is ignored, then it will certainly not be possible to fashion monetary value so that it will generally be considered satisfactory. In view of the ideas prevailing today with respect to trade policy, especially in connection with foreign relations, a rising value for money is not considered desirable, because of its power to promote imports and to hamper exports.

Attempts to introduce a national policy, so as to influence prices independently of what is happening abroad, while still clinging to the gold standard and the corresponding rates of exchange, would be completely unworkable. There is no need to say any more about this.

4.

The Future

The obstacles which militate against a policy aimed at the complete elimination of cyclical changes are truly considerable. For that reason, it is not very likely that such new approaches to monetary and banking policy, that limit the creation of fiduciary media, will be followed. It will probably not be resolved to prohibit entirely the expansion of fiduciary media. Nor is it likely that expansion will be limited to only the quantities sufficient to counteract a definite and pronounced trend toward generally declining prices. Perplexed as to how to evaluate the serious political and economic doubts which are raised in opposition to every kind of manipulation of the value of money, the people will probably forego decisive action and leave it to the central bank managers to proceed, case by case, at their own discretion. Just as in the past, cyclical policy of the near future will be surrendered into the hands of the men who control the conduct of the great central banks and those who influence their ideas, i.e., the moulders of public opinion.

Nevertheless, the cyclical policy of the future will differ appreciably from its predecessor. It will be knowingly based on the Circulation Credit Theory of the Trade Cycle. The hopeless attempt to reduce the loan rate indefinitely by continuously expanding circulation credit will not be revived in the future. It may be that the quantity of fiduciary media will be intentionally expanded or contracted in order to influence purchasing power. However, the people will no longer be under the illusion that technical banking procedures can make credit cheaper and thus create prosperity without its having repercussions.

The only way to do away with, or even to alleviate, the periodic return of the trade cycle—with its denouement, the crisis—is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap.

The Causes of the Economic Crisis An Address

I

The Nature and Role of the Market

1.

The Marxian “Anarchy of Production” Myth*

The Marxian critique censures the capitalistic social order for the anarchy and planlessness of its production methods. Allegedly, every entrepreneur produces blindly, guided only by his desire for profit, without any concern as to whether his action satisfies a need. Thus, for Marxists, it is not surprising if severe disturbances appear again and again in the form of periodical economic crises. They maintain it would be futile to fight against all this with capitalism. It is their contention that only socialism will provide the remedy by replacing the anarchistic profit economy with a planned economic system aimed at the satisfaction of needs.

Strictly speaking, the reproach that the market economy is “anarchistic” says no more than that it is just not socialistic. That is, the actual management of production is not surrendered to a central office which directs the employment of all factors of production, but this is left to entrepreneurs and owners of the means of production. Calling the capitalistic economy “anarchistic,” therefore, means only that capitalistic production is not a function of governmental institutions.

Yet, the expression “anarchy” carries with it other connotations. We usually use the word “anarchy” to refer to social conditions in which, for lack of a governmental apparatus of force to protect peace and respect for the law, the chaos of continual conflict prevails. The word “anarchy,” therefore, is associated with the concept of intolerable conditions. Marxian theorists delight in using such expressions. Marxian theory needs the implications such expressions give to arouse the emotional sympathies and antipathies that are likely to hinder critical analysis. The “anarchy of production” slogan has performed this service to perfection. Whole generations have permitted it to confuse them. It has influenced the economic and political ideas of all currently active political parties and, to a remarkable extent, even those parties which loudly proclaim themselves anti-Marxist.

2.

The Role and Rule of Consumers

Even if the capitalistic method of production were “anarchistic,” i.e., lacking systematic regulation from a central office, and even if individual entrepreneurs and capitalists did, in the hope of profit, direct their actions independently of one another, it is still completely wrong to suppose they have no guide for arranging production to satisfy need. It is inherent in the nature of the capitalistic economy that, in the final analysis, the employment of the factors of production is aimed only toward serving the wishes of consumers. In allocating labor and capital goods, the entrepreneurs and the capitalists are bound, by forces they are unable to escape, to satisfy the needs of consumers as fully as possible, given the state of economic wealth and technology. Thus, the contrast drawn between the capitalistic method of production, as production for profit, and the socialistic method, as production for use, is completely misleading. In the capitalistic economy, it is consumer demand that determines the pattern and direction of production, precisely because entrepreneurs and capitalists must consider the profitability of their enterprises.

An economy based on private ownership of the factors of production becomes meaningful through the market. The market operates by shifting the height of prices so that again and again demand and supply will tend to coincide. If demand for a good goes up, then its price rises, and this price rise leads to an increase in supply. Entepreneurs try to produce those goods the sale of which offers them the highest possible gain. They expand production of any particular item up to the point at which it ceases to be profitable. If the entrepreneur produces only those goods whose sale gives promise of yielding a profit, this means that they are producing no commodities for the manufacture of which labor and capital goods must be used which are needed for the manufacture of other commodities more urgently desired by consumers.

In the final analysis, it is the consumers who decide what shall be produced, and how. The law of the market compels entrepreneurs and capitalists to obey the orders of consumers and to fulfill their wishes with the least expenditure of time, labor and capital goods. Competition on the market sees to it that entrepreneurs and capitalists, who are not up to this task, will lose their position of control over the production process. If they cannot survive in competition, that is, in satisfying the wishes of consumers cheaper and better, then they suffer losses which diminish their importance in the economic process. If they do not soon correct the shortcomings in the management of their enterprise and capital investment, they are eliminated completely through the loss of their capital and entrepreneurial position. Henceforth, they must be content as employees with a more modest role and reduced income.

3.

Production for Consumption

The law of the market applies to labor also. Like other factors of production, labor is also valued according to its usefulness in satisfying human wants. Its price, the wage rate, is a market phenomenon like any other market phenomenon, determined by supply and demand, by the value the product of labor has in the eye of consumers. By shifting the height of wages, the market directs workers into those branches of production in which they are most urgently needed. Thus the market supplies to each type of employment that quality and quantity of labor needed to satisfy consumer wants in the best possible way.

In the feudal society, men became rich by war and conquest and through the largesse of the sovereign ruler. Men became poor if they were defeated in battle or if they fell from the monarch’s good graces. In the capitalistic society, men become rich—directly as the producer of consumers’ goods, or indirectly as the producer of raw materials and semi-produced factors of production—by serving consumers in large numbers. This means that men who become rich in the capitalistic society are serving the people. The capitalistic market economy is a democracy in which every penny constitutes a vote. The wealth of the successful businessman is the result of a consumer plebiscite. Wealth, once acquired, can be preserved only by those who keep on earning it anew by satisfying the wishes of consumers.

The capitalistic social order, therefore, is an economic democracy in the strictest sense of the word. In the last analysis, all decisions are dependent on the will of the people as consumers. Thus, whenever there is a conflict between consumers’ views and those of the business managers, market pressures assure that the views of the consumers win out eventually. This is certainly something very different from the pseudo-economic democracy toward which the labor unions are aiming. In such a system as they propose, the people are supposed to direct production as producers, not as consumers. They would exercise influence, not as buyers of products, but as sellers of labor, that is, as sellers of one of the factors of production. If this system were carried out, it would disorganize the entire production apparatus and thus destroy our civilization. The absurdity of this position becomes apparent simply upon considering that production is not an end in itself. Its purpose is to serve consumption.

4.

The Perniciousness of a “Producers’ Policy”

Under pressure of the market, entrepreneurs and capitalists must order production so as to carry out the wishes of consumers. The arrangements they make and what they ask of workers are always determined by the need to satisfy the most urgent wants of consumers. It is precisely this which guarantees that the will of the consumer shall be the only guideline for business. Yet capitalism is usually reproached for placing the logic of expediency above sentiment and arranging things in the economy dispassionately and impersonally for monetary profit only. It is because the market compels the entrepreneur to conduct his business so that he derives from it the greatest possible return that the wants of consumers are covered in the best and cheapest way. If potential profit were no longer taken into consideration by enterprises, but instead the workers’ wishes became the criterion, so that work was arranged for their greatest convenience, then the interests of consumers would be injured. If the entrepreneur aims at the highest possible profit, he performs a service to society in managing an enterprise. Whoever hinders him from doing this, in order to give preference to considerations other than those of business profits, acts against the interests of society and imperils the satisfaction of consumer needs.

Workers and consumers are, of course, identical. If we distinguish between them, we are only differentiating mentally between their respective functions within the economic framework. We should not let this lead us into the error of thinking they are different groups of people. The fact that entrepreneurs and capitalists also are consuming plays a less important role quantitatively; for the market economy, the significant consumption is mass consumption. Directly or indirectly, capitalistic production serves primarily the consumption of the masses. The only way to improve the situation of the consumer, therefore, is to make enterprises still more productive, or as people may say today, to “rationalize”1 still further. Only if one wants to reduce consumption should one urge what is known as “producers’ policy”—specifically the adoption of those measures which place the interests of producers over those of consumers.

Opposition to the economic laws which the market decrees for production must always be at the expense of consumption. This should be kept in mind whenever interventions are advocated to free producers from the necessity of complying with the market.

The market processes give meaning to the capitalistic economy. They place entrepreneurs and capitalists in the service of satisfying the wants of consumers. If the workings of these complex processes are interfered with, then disturbances are brought about which hamper the adjustment of supply to demand and lead production astray, along paths which keep them from attaining the goal of economic action— i.e., the satisfaction of wants.

These disturbances constitute the economic crisis.

II

Cyclical Changes in Business Conditions

1.

Role of Interest Rates

In our economic system, times of good business commonly alternate more or less regularly with times of bad business. Decline follows economic upswing, upswing follows decline, and so on. The attention of economic theory has quite understandably been greatly stimulated by this problem of cyclical changes in business conditions. In the beginning, several hypotheses were set forth, which could not stand up under critical examination. However, a theory of cyclical fluctuations was finally developed which fulfilled the demands legitimately expected from a scientific solution to the problem. This is the Circulation Credit Theory, usually called the Monetary Theory of the Trade Cycle. This theory is generally recognized by science. All cyclical policy measures which are taken seriously proceed from the reasoning which lies at the root of this theory.

According to the Circulation Credit Theory (Monetary Theory of the Trade Cycle), cyclical changes in business conditions stem from attempts to reduce artificially the interest rates on loans through measures of banking policy—expansion of bank credit by the issue or creation of additional fiduciary media (that is banknotes and/or checking deposits not covered 100% by gold). On a market which is not disturbed by the interference of such an “inflationist” banking policy, interest rates develop at which the means are available to carry out all the plans and enterprises that are initiated. Such unhampered market interest rates are known as “natural” or “static” interest rates. If these interest rates were adhered to, then economic development would proceed without interruption—except for the influence of natural cataclysms of political acts such as war, revolution, and the like. The fact that economic development follows a wavy pattern must be attributed to the intervention of the banks through their interest rate policy.

The point of view prevails generally among politicians, business people, the press and public opinion that reducing the interest rates below those developed by market conditions is a worthy goal for economic policy, and that the simplest way to reach this goal is through expanding bank credit. Under the influence of this view, the attempt is undertaken, again and again, to spark an economic upswing through granting additional loans. At first, to be sure, the result of such credit expansion comes up to expectations. Business is revived. An upswing develops. However, the stimulating effect emanating from the credit expansion cannot continue forever. Sooner or later, a business boom created in this way must collapse.

At the interest rates which developed on the market, before any interference by the banks through the creation of additional circulation credit, only those enterprises and businesses appeared profitable for which the needed factors of production were available in the economy. The interest rates are reduced through the expansion of credit, and then some businesses, which did not previously seem profitable, appear to be profitable. It is precisely the fact that such businesses are undertaken that initiates the upswing. However, the economy is not wealthy enough for them. The resources they need for completion are not available. The resources they need must first be withdrawn from other enterprises. If the means had been available, then the credit expansion would not have been necessary to make the new projects appear possible.

2.

The Sequel of Credit Expansion

Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.

Sooner or later, credit expansion, through the creation of additional fiduciary media, must come to a standstill. Even if the banks wanted to, they could not carry on this policy indefinitely, not even if they were being forced to do so by the strongest pressure from outside. The continuing increase in the quantity of fiduciary media leads to continual price increases. Inflation can continue only so long as the opinion persists that it will stop in the foreseeable future. However, once the conviction gains a foothold that the inflation will not come to a halt, then a panic breaks out. In evaluating money and commodities, the public takes anticipated price increases into account in advance. As a consequence, prices race erratically upward out of all bounds. People turn away from using money which is compromised by the increase in fiduciary media. They “flee” to foreign money, metal bars, “real values,” barter. In short, the currency breaks down.

The policy of expanding credit is usually abandoned well before this critical point is reached. It is discontinued because of the situation which develops in international trade relations and also, especially, because of experiences in previous crises, which have frequently led to legal limitations on the right of the central banks to issue notes and create credit. In any event, the policy of expanding credit must come to an end—if not sooner due to a turnabout by the banks, then later in a catastrophic breakdown. The sooner the credit expansion policy is brought to a stop, the less harm will have been done by the misdirection of entrepreneurial activity, the milder the crisis and the shorter the following period of economic stagnation and general depression.

The appearance of periodically recurring economic crises is the necessary consequence of repeatedly renewed attempts to reduce the “natural” rates of interest on the market by means of banking policy. The crises will never disappear so long as men have not learned to avoid such pump-priming, because an artificially stimulated boom must inevitably lead to crisis and depression.

III

The Present Crisis

The crisis from which we are now suffering is also the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the “natural rate of interest” through increasing the fiduciary media. However, the present crisis differs in some essential points from earlier crises, just as the preceding boom differed from earlier economic upswings.

The most recent boom period did not run its course completely, at least not in Europe. Some countries and some branches of production were not generally or very seriously affected by the upswing which, in many lands, was quite turbulent. A bit of the previous depression continued, even into the upswing. On that account—in line with our theory and on the basis of past experience—one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.

The unprofitability of many branches of production and the unemployment of a sizeable portion of the workers can obviously not be due to the slowdown in business alone. Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.

Let us consider, first of all, unemployment.

[1. ]Also, as a result of this, it became easier to distinguish crises originating from definite causes (wars and political upheavals, violent convulsions of nature, changes in the shape of supply or demand) from cyclically-recurring crises.

[2. ][The Post Office Savings Institution, established in Austria in the 1880s and copied in several other European countries, played a significant, if limited, role in monetary affairs. See Mises’s comments in Human Action (1966, 1996, and 2007), pp. 445–446.—Ed.]

[3. ]Keynes, John Maynard. A Tract on Monetary Reform. London, 1923; New York, 1924, pp. 156ff.

[* ][Die Ursachen der Wirtschaftskrise: Ein Vortrag (Tübingen: J. C. B. Mohr, Paul Siebeck, 1931). Presented February 28, 1931, at Teplitz-Schönau, Czechoslovakia, before an assembly of German industrialists (Deutscher Hauptverband der Industrie).—Ed.]

[1. ][A loose term for a more efficient organization of industrial production through the use of more modern technical automation and mechanization. It came in time to imply that central planning and government regulation are helpful in eliminating “wasteful” competition. The term was later applied to the Nazi and Soviet plans for industrial organization.—Ed.]