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D.: GOLD PRODUCTION - 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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The Decline in Prices
One popular doctrine blames the crisis on the insufficiency of gold production.
The basic error in this attempt to explain the crisis rests on equating a drop in prices with a crisis. A slow, steady, downward slide in the prices of all goods and services could be explained by the relationship to the production of gold. Businessmen have become accustomed to a relationship of the demand for, and supply of, gold from which a slow steady rise in prices emerges as a secular (continuing) trend. However, they could just as easily have become reconciled to some other arrangement—and they certainly would have if developments had made that necessary. After all, the businessman’s most important characteristic is flexibility. The businessman can operate at a profit, even if the general tendency of prices is downward, and economic conditions can even improve then too.
The turbulent price declines since 1929 were definitely not generated by the gold production situation. moreover, gold production has nothing to do with the fact that the decline in prices is not universal, nor that it does not specifically involve wages also.
It is true that there is a close connection between the quantity of gold produced and the formation of prices. Fortunately, this is no longer in dispute. If gold production had been considerably greater than it actually was in recent years, then the drop in prices would have been moderated or perhaps even prevented from appearing. It would be wrong, however, to assume that the phenomenon of the crisis would not then have occurred. The attempts of labor unions to drive wages up higher than they would have been on the unhampered market and the efforts of governments to alleviate the difficulties of various groups of producers have nothing to do with whether actual money prices are higher or lower.
Labor unions no longer contend over the height of money wages, but over the height of real wages. It is not because of low prices that producers of rye, wheat, coffee and so on are impelled to ask for government interventions. It is because of the unprofitability of their enterprises. However, the profitability of these enterprises would be no greater, even if prices were higher. For if the gold supply had been increased, not only would the prices of the products which the enterprises in question produce and want to sell have become or have remained proportionately higher, but so also would the prices of all the goods which comprise their costs. Then too, as in any inflation, an increase in the gold supply does not affect all prices at the same time, nor to the same extent. It helps some groups in the economy and hurts others. Thus no reason remains for assuming that an increase in the gold supply must, in a particular case, improve the situation for precisely those producers who now have cause to complain about the unprofitability of their undertakings. It could be that their situation would not only not be improved; it might even be worsened.
The error in equating the drop in prices with the crisis and, thus, considering the cause of this crisis to be the insufficient production of gold is especially dangerous. It leads to the view that the crisis could be overcome by increasing the fiduciary media in circulation. Thus the banks are asked to stimulate business conditions with the issue of additional banknotes and an additional credit expansion through credit entries. At first, to be sure, a boom can be generated in this way. However, as we have seen, such an upswing must eventually lead to a collapse in the business outlook and a new crisis.
Inflation as a “Remedy”
It is astonishing that sincere persons can either make such a demand or lend it support. Every possible argument in favor of such a scheme has already been raised a hundred times, and demolished a thousand times over. Only one argument is new, although on that account no less false. This is to the effect that the higher than unhampered market wage rates can be brought into proper relationship most easily by an inflation.
This argument shows how seriously concerned our political economists are to avoid displeasing the labor unions. Although they cannot help but recognize that wage rates are too high and must be reduced, they dare not openly call for a halt to such overpayments. Instead, they propose to outsmart the unions in some way. They propose that the actual money wage rate remain unchanged in the coming inflation. In effect, this would amount to reducing the real wage. This assumes, of course, that the unions will refrain from making further wage demands in the ensuing boom and that they will, instead, remain passive while their real wage rates deteriorate. Even if this entirely unjustified optimistic expectation is accepted as true, nothing is gained thereby. A boom caused by banking policy measures must still lead eventually to a crisis and a depression. So, by this method, the problem of lowering wage rates is not resolved but simply postponed.
yet, all things considered, many may think it advantageous to delay the unavoidable showdown with labor union policy. However, this ignores the fact that, with each artificial boom, large sums of capital are malinvested and, as a result, wasted. Every diminution in society’s stock of capital must lead toward a reduction in the “natural” or “static” wage rate. Thus, postponing the decision costs the masses a great deal. moreover, it will make the final confrontation still more difficult, rather than easier.
Is There a Way Out?
The Cause of Our Difficulties
The severe convulsions of the economy are the inevitable result of policies which hamper market activity, the regulator of capitalistic production. If everything possible is done to prevent the market from fulfilling its function of bringing supply and demand into balance, it should come as no surprise that a serious disproportionality between supply and demand persists, that commodities remain unsold, factories stand idle, many millions are unemployed, destitution and misery are growing and that finally, in the wake of all these, destructive radicalism is rampant in politics.
The periodically returning crises of cyclical changes in business conditions are the effect of attempts, undertaken repeatedly, to underbid the interest rates which develop on the unhampered market. These attempts to underbid unhampered market interest rates are made through the intervention of banking policy—by credit expansion through the additional creation of uncovered notes and checking deposits—in order to bring about a boom. The crisis under which we are now suffering is of this type, too. However, it goes beyond the typical business cycle depression, not only in scale but also in character— because the interventions with market processes which evoked the crisis were not limited only to influencing the rate of interest. The interventions have directly affected wage rates and commodity prices, too.
With the economic crisis, the breakdown of interventionist economic policy—the policy being followed today by all governments, irrespective of whether they are responsible to parliaments or rule openly as dictatorships—becomes apparent. This catastrophe obviously comes as no surprise. Economic theory has long been predicting such an outcome to interventionism.
The capitalistic economic system, that is the social system based on private ownership of the means of production, is rejected unanimously today by all political parties and governments. No similar agreement may be found with respect to what economic system should replace it in the future. Many, although not all, look to socialism as the goal. They stubbornly reject the result of the scientific examination of the socialistic ideology, which has demonstrated the unworkability of socialism. They refuse to learn anything from the experiences of the Russian and other European experiments with socialism.
The Unwanted Solution
Concerning the task of present economic policy, however, complete agreement prevails. The goal is an economic arrangement which is assumed to represent a compromise solution, the “middle-of-the-road” between socialism and capitalism. To be sure, there is no intent to abolish private ownership of the means of production. Private property will be permitted to continue, although directed, regulated and controlled by government and by other agents of society’s coercive apparatus. With respect to this system of interventionism, the science of economics points out, with incontrovertible logic, that it is contrary to reason; that the interventions which go to make up the system can never accomplish the goals their advocates hope to attain, and that every intervention will have consequences no one wanted.
The capitalistic social order acquires meaning and purpose through the market. Hampering the functions of the market and the formation of prices does not create order. Instead it leads to chaos, to economic crisis.
All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis: Forego every attempt to prevent the impact of market prices on production. Give up the pursuit of policies which seek to establish interest rates, wage rates and commodity prices different from those the market indicates. This may contradict the prevailing view. It certainly is not popular. Today all governments and political parties have full confidence in interventionism and it is not likely that they will abandon their program. However, it is perhaps not too optimistic to assume that those governments and parties whose policies have led to this crisis will some day disappear from the stage and make way for men whose economic program leads not to destruction and chaos, but to economic development and progress.
The Current Status of Business Cycle Research and Its Prospects for the Immediate Future
The Acceptance of the Circulation Credit Theory of Business Cycles*
It is frequently claimed that if the causes of cyclical changes were understood, economic programs suitable for smoothing out cyclical “waves” would be adopted. The upswing would then be throttled down in time to soften the decline that inevitably follows in its wake. As a result, economic development would proceed at a more even pace. The boom’s accompanying side effects, considered by many to be undesirable, would then be substantially, perhaps entirely, eliminated. Most significantly, however, the losses inflicted by the crisis and by the decline, which almost everyone deplores, would be considerably reduced, or even completely avoided.
For many people, this prospect has little appeal. In their opinion, the disadvantages of the depression are not too high a price to pay for the prosperity of the upswing. They say that not everything produced during the boom period is malinvestment, which must be liquidated by the crisis. In their opinion, some of the fruits of the boom remain and the progressing economy cannot do without them. However, most economists have looked on the elimination of cyclical changes as both desirable and necessary. Some came to this position because they thought that, if the economy were spared the shock of recurring crises every few years, it would help to preserve the capitalistic system of which they approved. Others have welcomed the prospect of an age without crises precisely because they saw—in an economy that was not disturbed by business fluctuations—no difficulties in the elimination of the entrepreneurs who, in their view, were merely the superfluous beneficiaries of the efforts of others.
Whether these authors looked on the prospect of smoothing out cyclical waves as favorable or unfavorable, all were of the opinion that a more thorough examination of the cause of periodic economic changes would help produce an age of less severe fluctuations. Were they right?
Economic theory cannot answer this question—it is not a theoretical problem. It is a problem of economic policy or, more precisely, of economic history. Although their measures may produce badly muddled results, the persons responsible for directing the course of economic policy are better informed today concerning the consequences of an expansion of circulation credit than were their earlier counterparts, especially those on the European continent. Yet, the question remains. Will measures be introduced again in the future which must lead via a boom to a bust?
The Circulation Credit (Monetary) Theory of the Trade Cycle must be considered the currently prevailing doctrine of cyclical change. Even persons who hold another theory find it necessary to make concessions to the Circulation Credit Theory. Every suggestion made for counteracting the present economic crisis uses reasoning developed by the Circulation Credit Theory. Some insist on rescuing every price from momentary distress, even if such distress comes in the upswing following a new crisis. To do this, they would “prime the pump” by further expanding the quantity of fiduciary media. Others oppose such artificial stimulation, because they want to avoid the illusory credit expansion induced prosperity and the crisis that will inevitably follow.
However, even those who advocate programs to spark and stimulate a boom recognize, if they are not completely hopeless dilettantes and ignoramuses, the conclusiveness of the Circulation Credit Theory’s reasoning. They do not contest the truth of the Circulation Credit Theory’s objections to their position. Instead, they try to ward them off by pointing out that they propose only a “moderate,” a carefully prescribed “dosage” of credit expansion or “monetary creation” which, they say, would merely soften, or bring to a halt, the further decline of prices. Even the term “re-deflation,” newly introduced in this connection with such enthusiasm, implies recognition of the Circulation Credit Theory. However, there are also fallacies implied in the use of this term.
The Popularity of Low Interest Rates
The credit expansion which evokes the upswing always originates from the idea that business stagnation must be overcome by “easy money.” Attempts to demonstrate that this is not the case have been in vain. If anyone argues that lower interest rates have not been constantly portrayed as the ideal goal for economic policy, it can only be due to lack of knowledge concerning economic history and recent economic literature. Practically no one has dared to maintain that it would be desirable to have higher interest rates sooner.1 People who sought cheap credit clamored for the establishment of credit-issuing banks and for these banks to reduce interest rates. Every measure seized upon to avoid “raising the discount rate” has had its roots in the concept that credit must be made “easy.” The fact that reducing interest rates through credit expansion must lead to price increases has generally been ignored. However, the cheap money policy would not have been abandoned even if this had been recognized.
Public opinion is not committed to one single view with respect to the height of prices as it is in the case of interest rates. Concerning prices, there have always been two different views: On the one side, the demand of producers for higher prices and, on the other side, the demand of consumers for lower prices. Governments and political parties have championed both demands, if not at the same time, then shifting from time to time according to the groups of voters whose favors they court at the moment. First one slogan, then another is inscribed on their banners, depending on the temporary shift of prices desired. If prices are going up, they crusade against the rising cost of living. If prices are falling, they profess their desire to do everything possible to assure “reasonable” prices for producers. Still, when it comes to trying to reduce prices, they generally sponsor programs which cannot attain that goal. No one wants to adopt the only effective means—the limitation of circulation credit—because they do not want to drive interest rates up.2 In times of declining prices, however, they have been more than ready to adopt credit expansion measures, as this goal is attainable by the means already desired, i.e., by reducing interest rates.
Today, those who would seek to expand circulation credit counter objections by explaining that they only want to adjust for the decline in prices that has already taken place in recent years, or at least to prevent a further decline in prices. Thus, it is claimed, such expansion introduces nothing new. Similar arguments were also heard [during the nineteenth century] at the time of the drive for bimetallism.
The Popularity of Labor Union Policy
It is generally recognized that the social consequences of changes in the value of money—apart from the effect such changes have on the value of monetary obligations—may be attributed solely to the fact that these changes are not effected equally and simultaneously with respect to all goods and services. That is, not all prices rise to the same extent and at the same time. Hardly anyone disputes this today. Moreover, it is no longer denied, as it generally was a few years ago, that the duration of the present crisis is caused primarily by the fact that wage rates and certain prices have become inflexible, as a result of union wage policy and various price support activities. Thus, the rigid wage rates and prices do not fully participate in the downward movement of most prices, or do so only after a protracted delay. In spite of all contradictory political interventions, it is also admitted that the continuing mass unemployment is a necessary consequence of the attempts to maintain wage rates above those that would prevail on the unhampered market. However, in forming economic policy, the correct inference from this is not drawn.
Almost all who propose priming the pump through credit expansion consider it self-evident that money wage rates will not follow the upward movement of prices until their relative excess [over the earlier market prices] has disappeared. Inflationary projects of all kinds are agreed to because no one openly dares to attack the union wage policy, which is approved by public opinion and promoted by government. Therefore, so long as today’s prevailing view concerning the maintenance of higher than unhampered market wage rates and the interventionist measures supporting them exists, there is no reason to assume that money wage rates can be held steady in a period of rising prices.
The Effect of Lower than Unhampered Market Interest Rates
The causal connection [between credit expansion and rising prices] is denied still more intensely if the proposal for limiting credit expansion is tied in with certain anticipations. If the entrepreneurs expect low interest rates to continue, they will use the low interest rates as a basis for their computations. Only then will entrepreneurs allow themselves to be tempted, by the offer of more ample and cheaper credit, to consider business enterprises which would not appear profitable at the higher interest rates that would prevail on the unaltered loan market.
If it is publicly proclaimed that care will be taken to stop the creation of additional credit in time, then the hoped-for gains must fail to appear. No entrepreneur will want to embark on a new business if it is clear to him in advance that the business cannot be carried through to completion successfully. The failure of recent pump-priming attempts and statements of the authorities responsible for banking policy make it evident that the time of cheap money will very soon come to an end. If there is talk of restriction in the future, one cannot continue to “prime the pump” with credit expansion.
Economists have long known that every expansion of credit must someday come to an end and that, when the creation of additional credit stops, this stoppage must cause a sudden change in business conditions. A glance at the daily and weekly press in the “boom” years since the middle of the last century shows that this understanding was by no means limited to a few persons. Still the speculators, averse to theory as such, did not know it, and they continued to engage in new enterprises. However, if the governments were to let it be known that the credit expansion would continue only a little longer, then its intention to stop expanding would not be concealed from anyone.
The Questionable Fear of Declining Prices
People today are inclined to over value the significance of recent accomplishments in clarifying the business cycle problem and to under- value the Currency School’s tremendous contribution. The benefit which practical cyclical policy could derive from the old Currency School theoreticians has still not been fully exploited. Modern cyclical theory has contributed little to practical policy that could not have been learned from the Currency Theory.
Unfortunately, economic theory is weakest precisely where help is most needed—in analyzing the effects of declining prices. A general decline in prices has always been considered unfortunate. Yet today, even more than ever before, the rigidity of wage rates and the costs of many other factors of production hamper an unbiased consideration of the problem. Therefore, it would certainly be timely now to investigate thoroughly the effects of declining money prices and to analyze the widely held idea that declining prices are incompatible with the increased production of goods and services and an improvement in general welfare. The investigation should include a discussion of whether it is true that only inflationistic steps permit the progressive accumulation of capital and productive facilities. So long as this naive inflationist theory of development is firmly held, proposals for using credit expansion to produce a boom will continue to be successful.
The Currency Theory described some time ago the necessary connection between credit expansion and the cycle of economic changes. Its chain of reasoning was only concerned with a credit expansion limited to one nation. It did not do justice to the situation, of special importance in our age of attempted cooperation among the banks of issue, in which all countries expanded equally. In spite of the Currency Theory’s explanation, the banks of issue have persistently advised further expansion of credit.
This strong drive on the part of the banks of issue may be traced back to the prevailing idea that rising prices are useful and absolutely necessary for “progress” and to the belief that credit expansion was a suitable method for keeping interest rates low. The relationship between the issue of fiduciary media and the formation of interest rates is sufficiently explained today, at least for the immediate requirements of determining economic policy. However, what still remains to be explained satisfactorily is the problem of generally declining prices.
The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money
The author of this paper is fully aware of its insufficiency. Yet, there is no means of dealing with the problem of the trade cycle in a more satisfactory way if one does not write a treatise embracing all aspects of the capitalist market economy. The author fully agrees with the dictum of Böhm-Bawerk: “A theory of the trade cycle, if it is not to be mere botching, can only be written as the last chapter or the last chapter but one of a treatise dealing with all economic problems.”
It is only with these reservations that the present writer presents this rough sketch to the members of the Committee.
The Unpopularity of Interest
One of the characteristic features of this age of wars and destruction is the general attack launched by all governments and pressure groups against the rights of creditors. The first act of the Bolshevik government was to abolish loans and payment of interest altogether. The most popular of the slogans that swept the Nazis into power was Brechung der Zinsknechtschaft, abolition of interest-slavery. The debtor countries are intent upon expropriating the claims of foreign creditors by various devices, the most efficient of which is foreign exchange control. Their economic nationalism aims at brushing away an alleged return to colonialism. They pretend to wage a new war of independence against the foreign exploiters as they venture to call those who provided them with the capital required for the improvement of their economic conditions. As the foremost creditor nation today is the United States, this struggle is virtually directed against the American people. Only the old usages of diplomatic reticence make it advisable for the economic nationalists to name the devil they are fighting not the Yankees, but “Wall Street.”
“Wall Street” is no less the target at which the monetary authorities of this country are directing their blows when embarking upon an “easy money” policy. It is generally assumed that measures designed to lower the rate of interest below the height at which the unhampered market would fix it are extremely beneficial to the immense majority at the expense of a small minority of capitalists and hardboiled money-lenders. It is tacitly implied that the creditors are the idle rich while the debtors are the industrious poor. However, this belief is atavistic and utterly misjudges contemporary conditions.
In the days of Solon, Athens’ wise legislator, in the time of ancient Rome’s agrarian laws, in the Middle Ages and even for some centuries later, one was by and large right in identifying the creditors with the rich and the debtors with the poor. It is quite different in our age of bonds and debentures, of savings banks, of life insurance and social security. The proprietory classes are the owners of big plants and farms, of common stock, of urban real estate and, as such, they are very often debtors. The people of more modest income are bondholders, owners of saving deposits and insurance policies and beneficiaries of social security. As such, they are creditors. Their interests are impaired by endeavors to lower the rate of interest and the national currency’s purchasing power.
It is true that the masses do not think of themselves as creditors and thus sympathize with the anti-creditor policies. However, this ignorance does not alter the fact that the immense majority of the nation are to be classified as creditors and that these people, in approving of an “easy money” policy, unwittingly hurt their own material interests. It merely explodes the Marxian fable that a social class never errs in recognizing its particular class interests and always acts in accordance with these interests.
The modern champions of the “easy money” policy take pride in calling themselves unorthodox and slander their adversaries as orthodox, old-fashioned and reactionary. One of the most eloquent spokesmen of what is called functional finance, Professor Abba Lerner, pretends that in judging fiscal measures he and his friends resort to what “is known as the method of science as opposed to scholasticism.” The truth is that Lord Keynes, Professor Alvin H. Hansen and Professor Lerner, in their passionate denunciation of interest, are guided by the essence of Medieval Scholasticism’s economic doctrine, the disapprobation of interest. While emphatically asserting that a return to the nineteenth century’s economic policies is out of the question, they are zealously advocating a revival of the methods of the Dark Ages and of the orthodoxy of old canons.
The Two Classes of Credit
There is no difference between the ultimate objectives of the anti-interest policies of canon law and the policies recommended by modern interest-baiting. But the methods applied are different. Medieval orthodoxy was intent first upon prohibiting by decree interest altogether and later upon limiting the height of interest rates by the so-called usury laws. Modern self-styled unorthodoxy aims at lowering or even abolishing interest by means of credit expansion.
Every serious discussion of the problem of credit expansion must start from the distinction between two classes of credit: commodity credit and circulation credit.
Commodity credit is the transfer of savings from the hands of the original saver into those of the entrepreneurs who plan to use these funds in production. The original saver has saved money by not consuming what he could have consumed by spending it for consumption. He transfers purchasing power to the debtor and thus enables the latter to buy these non-consumed commodities for use in further production. Thus the amount of commodity credit is strictly limited by the amount of saving, i.e., abstention from consumption. Additional credit can only be granted to the extent that additional savings have been accumulated. The whole process does not affect the purchasing power of the monetary unit.
Circulation credit is credit granted out of funds especially created for this purpose by the banks. In order to grant a loan, the bank prints banknotes or credits the debtor on a deposit account. It is creation of credit out of nothing. It is tantamount to the creation of fiat money, to undisguised, manifest inflation. It increases the amount of money substitutes, of things which are taken and spent by the public in the same way in which they deal with money proper. It increases the buying power of the debtors. The debtors enter the market of factors of production with an additional demand, which would not have existed except for the creation of such banknotes and deposits. This additional demand brings about a general tendency toward a rise in commodity prices and wage rates.
While the quantity of commodity credit is rigidly fixed by the amount of capital accumulated by previous saving, the quantity of circulation credit depends on the conduct of the bank’s business. Commodity credit cannot be expanded, but circulation credit can. Where there is no circulation credit, a bank can only increase its lending to the extent that the savers have entrusted it with more deposits. Where there is circulation credit, a bank can expand its lending by what is, curiously enough, called “being more liberal.”
Credit expansion not only brings about an inextricable tendency for commodity prices and wage rates to rise. It also affects the market rate of interest. As it represents an additional quantity of money offered for loans, it generates a tendency for interest rates to drop below the height they would have reached on a loan market not manipulated by credit expansion. It owes its popularity with quacks and cranks not only to the inflationary rise in prices and wage rates which it engenders, but no less to its short-run effect of lowering interest rates. It is today the main tool of policies aiming at cheap or easy money.
The Function of Prices, Wage Rates and Interest Rates
The rate of interest is a market phenomenon. In the market economy it is the structure of prices, wage rates and interest rates, as determined by the market, that directs the activities of the entrepreneurs toward those lines in which they satisfy the wants of the consumers in the best possible and cheapest way. The prices of the material factors of production, wage rates and interest rates on the one hand and the anticipated future prices of the consumers’ goods on the other hand are the items that enter into the planning businessman’s calculations. The result of these calculations shows the businessman whether or not a definite project will pay. If the market data underlying his calculations are falsified by the interference of the government, the result must be misleading. Deluded by an arithmetical operation with illusory figures, the entrepreneurs embark upon the realization of projects that are at variance with the most urgent desires of consumers. The disagreement of the consumers becomes manifest when the products of capital malinvestment reach the market and cannot be sold at satisfactory prices. Then, there appears what is called “bad business.”
If, on a market not hampered by government tampering with the market data, the examination of a definite project shows its unprofitability, it is proved that under the given state of affairs the consumers prefer the execution of other projects. The fact that a definite business venture is not profitable means that the consumers, in buying its products, are not ready to reimburse entrepreneurs for the prices of the complementary factors of production required, while on the other hand, in buying other products, they are ready to reimburse entrepreneurs for the prices of the same factors. Thus the sovereign consumers express their wishes and force business to adjust its activities to the satisfaction of those wants which they consider the most urgent. The consumers thus bring about a tendency for profitable industries to expand and for unprofitable ones to shrink.
It is permissible to say that what proximately prevents the execution of certain projects is the state of prices, wage rates and interest rates. It is a serious blunder to believe that if only these items were lower, production activities could be expanded. What limits the size of production is the scarcity of the factors of production. Prices, wage rates and interest rates are only indices expressive of the degree of this scarcity. They are pointers, as it were. Through these market phenomena, society sends out a warning to the entrepreneurs planning a definite project: Don’t touch this factor of production; it is earmarked for the satisfaction of another, more urgent need.
The expansionists, as the champions of inflation style themselves today, see in the rate of interest nothing but an obstacle to the expansion of production. If they were consistent, they would have to look in the same way at the prices of the material factors of production and at wage rates. A government decree cutting down wage rates to 50% of those on the unhampered labor market would likewise give to certain projects, which do not appear profitable in a calculation based on the actual market data, the appearance of profitability. There is no more sense in the assertion that the height of interest rates prevents a further expansion of production than in the assertion that the height of wage rates brings about these effects. The fact that the expansionists apply this kind of fallacious argumentation only to interest rates and not also to the prices of primary commodities and to the prices of labor is the proof that they are guided by emotions and passions and not by cool reasoning. They are driven by resentment. They envy what they believe is the rich man’s take. They are unaware of the fact that in attacking interest they are attacking the broad masses of savers, bondholders and beneficiaries of insurance policies.
The Effects of Politically Lowered Interest Rates
The expansionists are quite right in asserting that credit expansion succeeds in bringing about booming business. They are mistaken only in ignoring the fact that such an artificial prosperity cannot last and must inextricably lead to a slump, a general depression.
If the market rate of interest is reduced by credit expansion, many projects which were previously deemed unprofitable get the appearance of profitability. The entrepreneur who embarks upon their execution must, however, very soon discover that his calculation was based on erroneous assumptions. He has reckoned with those prices of the factors of production which corresponded to market conditions as they were on the eve of the credit expansion. But now, as a result of credit expansion, these prices have risen. The project no longer appears so promising as before. The businessman’s funds are not sufficient for the purchase of the required factors of production. He would be forced to discontinue the pursuit of his plans if the credit expansion were not to continue. However, as the banks do not stop expanding credit and providing business with “easy money,” the entrepreneurs see no cause to worry. They borrow more and more. Prices and wage rates boom. Everybody feels happy and is convinced that now finally mankind has overcome forever the gloomy state of scarcity and reached everlasting prosperity.
In fact, all this amazing wealth is fragile, a castle built on the sands of illusion. It cannot last. There is no means to substitute banknotes and deposits for non-existing capital goods. Lord Keynes, in a poetical mood, asserted that credit expansion has performed “the miracle . . . of turning a stone into bread.”1 But this miracle, on closer examination, appears no less questionable than the tricks of Indian fakirs.
There are only two alternatives.
One, the expanding banks may stubbornly cling to their expansionist policies and never stop providing the money business needs in order to go on in spite of the inflationary rise in production costs. They are intent upon satisfying the ever increasing demand for credit. The more credit business demands, the more it gets. Prices and wage rates sky-rocket. The quantity of banknotes and deposits increases beyond all measure. Finally, the public becomes aware of what is happening. People realize that there will be no end to the issue of more and more money substitutes—that prices will consequently rise at an accelerated pace. They comprehend that under such a state of affairs it is detrimental to keep cash. In order to prevent being victimized by the progressing drop in money’s purchasing power, they rush to buy commodities, no matter what their prices may be and whether or not they need them. They prefer everything else to money. They arrange what in 1923 in Germany, when the Reich set the classical example for the policy of endless credit expansion, was called die Flucht in die Sachwerte, the flight into real values. The whole currency system breaks down. Its unit’s purchasing power dwindles to zero. People resort to barter or to the use of another type of foreign or domestic money. The crisis emerges.
The other alternative is that the banks or the monetary authorities become aware of the dangers involved in endless credit expansion before the common man does. They stop, of their own accord, any further addition to the quantity of banknotes and deposits. They no longer satisfy the business applications for additional credits. Then the panic breaks out. Interest rates jump to an excessive level, because many firms badly need money in order to avoid bankruptcy. Prices drop suddenly, as distressed firms try to obtain cash by throwing inventories on the market dirt cheap. Production activities shrink, workers are discharged.
Thus, credit expansion unavoidably results in the economic crisis. In either of the two alternatives, the artificial boom is doomed. In the long run, it must collapse. The short-run effect, the period of prosperity, may last sometimes several years. While it lasts, the authorities, the expanding banks and their public relations agencies arrogantly defy the warnings of the economists and pride themselves on the manifest success of their policies. But when the bitter end comes, they wash their hands of it.
The artificial prosperity cannot last because the lowering of the rate of interest, purely technical as it was and not corresponding to the real state of the market data, has misled entrepreneurial calculations. It has created the illusion that certain projects offer the chances of profitability when, in fact, the available supply of factors of production was not sufficient for their execution. Deluded by false reckoning, businessmen have expanded their activities beyond the limits drawn by the state of society’s wealth. They have underrated the degree of the scarcity of factors of production and overtaxed their capacity to produce. In short: they have squandered scarce capital goods by malinvestment.
The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to construct a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He overbuilds the groundwork and the foundations and discovers only later, in the progress of the construction, that he lacks the material needed for the completion of the structure. This belated discovery does not create our master builder’s plight. It merely discloses errors committed in the past. It brushes away illusions and forces him to face stark reality.
There is need to stress this point, because the public, always in search of a scapegoat, is as a rule ready to blame the monetary authorities and the banks for the outbreak of the crisis. They are guilty, it is asserted, because in stopping the further expansion of credit, they have produced a deflationary pressure on trade. Now, the monetary authorities and the banks were certainly responsible for the orgies of credit expansion and the resulting boom; although public opinion, which always approves such inflationary ventures wholeheartedly, should not forget that the fault rests not alone with others. The crisis is not an outgrowth of the abandonment of the expansionist policy. It is the inextri-cable and unavoidable aftermath of this policy. The question is only whether one should continue expansionism until the final collapse of the whole monetary and credit system or whether one should stop at an earlier date. The sooner one stops, the less grievous are the damages inflicted and the losses suffered.
Public opinion is utterly wrong in its appraisal of the phases of the trade cycle. The artificial boom is not prosperity, but the deceptive appearance of good business. Its illusions lead people astray and cause malinvestment and the consumption of unreal apparent gains which amount to virtual consumption of capital. The depression is the necessary process of readjusting the structure of business activities to the real state of the market data, i.e., the supply of capital goods and the valuations of the public. The depression is thus the first step on the return to normal conditions, the beginning of recovery and the foundation of real prosperity based on the solid production of goods and not on the sands of credit expansion.
Additional credit is sound in the market economy only to the extent that it is evoked by an increase in the public’s savings and the resulting increase in the amount of commodity credit. Then, it is the public’s conduct that provides the means needed for additional investment. If the public does not provide these means, they cannot be conjured up by the magic of banking tricks. The rate of interest, as it is determined on a loan market not manipulated by an “easy money” policy, is expressive of the people’s readiness to withhold from current consumption a part of the income really earned and to devote it to a further expansion of business. It provides the businessman reliable guidance in determining how far he may go in expanding investment, what projects are in compliance with the true size of saving and capital accumulation and what are not. The policy of artificially lowering the rate of interest below its potential market height seduces the entrepreneurs to embark upon certain projects of which the public does not approve. In the market economy, each member of society has his share in determining the amount of additional investment. There is no means of fooling the public all of the time by tampering with the rate of interest. Sooner or later, the public’s disapproval of a policy of over-expansion takes effect. Then the airy structure of the artificial prosperity collapses.
Interest is not a product of the machinations of rugged exploiters. The discount of future goods as against present goods is an eternal category of human action and cannot be abolished by bureaucratic measures. As long as there are people who prefer one apple available today to two apples available in twenty-five years, there will be interest. It does not matter whether society is organized on the basis of private ownership of the means of production, viz., capitalism, or on the basis of public ownership, viz., socialism or communism. For the conduct of affairs by a totalitarian government, interest, the different valuation of present and of future goods, plays the same role it plays under capitalism.
Of course, in a socialist economy, the people are deprived of any means to make their own value judgments prevail and only the government’s value judgments count. A dictator does not bother whether or not the masses approve of his decision of how much to devote for current consumption and how much for additional investment. If the dictator invests more and thus curtails the means available for current consumption, the people must eat less and hold their tongues. No crisis emerges, because the subjects have no opportunity to utter their dissatisfaction. But in the market economy, with its economic democracy, the consumers are supreme. Their buying or abstention from buying creates entrepreneurial profit or loss. It is the ultimate yardstick of business activities.
The Inevitable Ending
It is essential to realize that what makes the economic crisis emerge is the public’s disapproval of the expansionist ventures made possible by the manipulation of the rate of interest. The collapse of the house of cards is a manifestation of the democratic process of the market.
It is vain to object that the public favors the policy of cheap money. The masses are misled by the assertions of the pseudo-experts that cheap money can make them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by savings. They are deceived by the fairy tales of monetary cranks from John Law down to Major C. H. Douglas. Yet, what counts in reality is not fairy tales, but people’s conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes or by loans on the bank books.
In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptising it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the artificial boom has caused. As things are now, after a long period of artificially low interest rates, the question is not how to avoid the hardships of the process of recovery altogether, but how to reduce them to a minimum. If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923.
[* ][Contribution to a Festschrift for Arthur Spiethoff, Die Stellung und der nächste Zukunft der Konjunkturforschung, pp. 175–180 (Munich: Duncker & Humblot, 1933). Mises addressed the subject of the Festschrift’s title.—Ed.]
[1. ]That has always been so; public opinion has always sided with the debtors. (See Jeremy, Bentham. Defence of Usury, 2nd ed., London, 1790, pp. 102ff.) The idea that the creditors are the idle rich, hardhearted exploiters of workers, and that the debtors are the unfortunate poor, has not been abandoned even in this age of bonds, bank deposits and savings accounts.
[2. ]An extreme example: the discount policy of the German Reichsbank in the time of inflation. See Graham, Frank. Exchange, Prices and Production in Hyper-Inflation Germany, 1920–1923. Princeton, 1930, pp. 65ff.
[* ][A memorandum, dated April 24, 1946, written in English by Professor Mises to a committee of businessmen.—Ed.]
[1. ]Paper of the British Experts, April 8, 1943.