The Austrian Theory of the Trade Cycle and Other Essays (LvMI)

by Richard M. Ebeling

What happened over the span of nearly forty years to account for the rise and fall of this theory of boom and bust? The simple answer, of course, is: the Keynesian revolution. John Maynard Keynes’s General Theory of Employment, Interest, and Money, which made its appearance in 1936, produced a major change in the way that economists deal with macro-economic issues. A close look at some pre-Keynesian ideas can show why the Austrian theory was so easily lost in the aftermath of the Keynesian revolution; a brief survey of the alternatives offered by modern macroeconomics will show why there is a new-found interest in this old Austrian theory.

The notion that the market process can be systematically affected by a divergence between the bank rate of interest and the natural rate came from Swedish economist Knut Wicksell;

market manipulation via altering bank interest rates.

Mises showed that an artificially low rate of interest, maintained by credit expansion, misallocates capital, making the production process too time-consuming in relation to the temporal pattern of consumer demand. As time eventually reveals the discrepancy, markets for both capital goods and consumer goods react to undo the misallocation. The initial misallocation and eventual reallocation constitute the microeconomic foundations that underlie the observed macroeconomic phenomenon of boom and bust. Mises’s theory was superior to its Swedish forerunner in that Wicksell was concerned almost exclusively with the effect of credit expansion on the general level of prices. It was superior to its British forerunner in that the currency school’s theory applied only when monetary expansion in one country outpaced that of its trading partners. Mises’s theory was applicable even to a closed economy and to a world economy in which all countries are experiencing a credit expansion.

Relief from the complexities of capital theory together with policy implications that were exceedingly attractive to elected officials gave Keynesianism an advantage over Austrian-ism. An easy-to-follow recipe for managing the macroeconomy won out over a difficult-to-follow theory that explains why such management is counterproductive.

Can the intertemporal misallocation of capital that occurs during the boom account for the length and depth of the depression? Haberler provides one of the best answers to this question—one that is most favorable to the Austrian theory—in his 1932 essay. The “maladjustment of the vertical structure of production,” to use Haberler’s own term, does not, by itself, account for the length and depth of the depression. Rather, this policy-induced change in the intertemporal structure of capital is the basis for the claim that a crisis and downturn are inevitable. The reallocation of resources that follows the downturn, which largely mirrors—both qualitatively and quantitatively—the earlier misallocation, involves an abnormally high level of (structural) unemployment but need not involve a deep and lengthy depression.

If, over a period of years, capital has been misallocated by an accelerating credit expansion, there is no policy that avoids a crisis. In the modern vernacular, there is no possibility of a “soft landing.”7 Decelerating the expansion will cause real interest rates to rise dramatically as credit becomes increasingly scarce; bankruptcies would follow. Further accelerating the expansion will cause hyperinflation and a collapse of the monetary system. Mises is telling us, in effect, that the central bank can print itself into trouble, but it cannot print itself out of trouble.

Banking system can cause inflation but cannot fix it with its tools

Conventional Keynesianism, whether in the guise of the principles-level Keynesian cross, the intermediate IS-LM, or the advanced AS/AD is formulated at a level of aggregation too high to bring the cyclical quality of boom and bust into full view. Worse, the development of these tools of analysis in the hands of the modern textbook industry has involved a serious sacrifice of substance in favor of pedagogy.

It is because it misunderstood this truth that the Currency School believed that it would suffice, in order to prevent the recurrence of economic crises, to enact legislation restricting the issue of bank notes without metallic backing, while leaving the expansion of credit by means of current accounts unregulated.

In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as “suppliers” of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated. The more active state of business leads to increased demand for production materials and for labor. The prices of the means of production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspon...

Currency, inflation in prices and wages, a useful summary.

But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money. Such is the phenomenon that occurred in Germany and in other countries that followed a policy of prolonged inflation

fear driven by inflation causes people to exchange fiat for any goods to escape rising inflation and devaluation of fiat currency.

Commodity prices rise enormously as do foreign exchange rates, while the price of the domestic money falls almost to zero. The value of the currency collapses, as was the case in Germany in 1923.

The crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared “profitable” in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be “profitable.” The capital invested in these enterprises is lost to the extent that it is locked in.

It is a well-known phenomenon, indeed, that in a period of depressions a very low rate of interest—considered from the arithmetical point of view—does not succeed in stimulating economic activity. The cash reserves of individuals and of banks grow, liquid funds accumulate, yet the depression continues.

This is the very simple reason why capitalists today are reluctant to tie themselves, through permanent investments, to a particular currency. This is why they allow their bank accounts to grow even though they return only very little interest, and hoard gold, which not only pays no interest, but also involves storage expenses.

The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.

Banks' policy of extending credit will always end in a crash

It has often been suggested to “stimulate” economic activity and to “prime the pump” by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.

stimulating a collapsed economy only postpones the problem and escalates it rather than resolving it.

What they all have in common is that the disturbing factors act through changes of the price level. It is through changes of the price level that expansion and contraction of credit and money act upon the economic system, and they all believe that stability of the price level is the sufficient criterion of a rational regulation of credit. If it were possible to keep the price level stable, prosperity would never be followed by depression. If the price level is allowed to rise and the inevitable reaction to come, it would be possible to end the depression and to restore equilibrium, if one could stop the fall of prices.

assumption that controlling the price level and resolve any economic difficulties.

From this it follows, and direct statistical investigations have verified it, that the volume of the circulating medium had been increased. We could say, there was a “relative inflation,” that is, an expansion of means of payment, which did not result in an increase of commodity prices, because it was just large enough to compensate for the effect of a parallel increase of the volume of production.

If we accept the proposition that the productive apparatus is out of gear, that great shifts of labor and capital are necessary to restore equilibrium, then it is emphatically not true that the business cycle is a purely monetary phenomenon,

The crucial point and also the point of deviation from Mr. Keynes’s analysis is to understand well that a reaction must inevitably set in, if this productive expansion is not financed by real, voluntary saving of individuals or corporations but by ad hoc created credit. And it is practically very important—the last boom should have brought this home to us—that a stable commodity price level is not a sufficient safeguard against such an artificial stimulation of an expansion of production. In other words, that a relative credit inflation, in the above-defined meaning of the term, will induce the same counter-movements as an absolute inflation.

credit inflation in production causing economic crash. Increased means of productions supported by expanding credit, which when it falls crashes the economy.

The easiest way of succeeding at this resolve was, simply to define “depressions” out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937–38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: “recession.” From that point on, we have been through quite a few recessions, but not a single depression.

terminology depression v recession is manipulated by media.

Beneath their diagrams, mathematics, and inchoate jargon, the attitude of Keynesians toward booms and bust is simplicity, even naivete, itself. If there is inflation, then the cause is supposed to be “excessive spending” on the part of the public; the alleged cure is for the government, the self-appointed stabilizer and regulator of the nation’s economy, to step in and force people to spend less, “sopping up their excess purchasing power” through increased taxation. If there is a recession, on the other hand, this has been caused by insufficient private spending, and the cure now is for the government to increase its own spending, preferably through deficits, thereby adding to the nation’s aggregate spending stream.

Keynsian solution to depression and inflation. Government is supposed to step in and solve the problem.

The function of the government is to be the wise old manager and physician, ever watchful, ever tinkering to keep the economic patient in good working order. In any case, here the economic patient is clearly supposed to be the subject, and the government as “physician” the master. It was not so long ago that this kind of attitude and policy was called “socialism”; but we live in a world of euphemism, and now we call it by far less harsh labels, such as “moderation” or “enlightened free enterprise.” We live and learn.

Since these cycles also appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. All the various current schools of economic thought, regardless of their other differences and the different causes that they attribute to the cycle, agree on this vital point: That these business cycles originate somewhere deep within the free-market economy. The market economy is to blame. Karl Marx believed that the periodic depressions would get worse and worse, until the masses would be moved to revolt and destroy the system, while the modern economists believe that the government can successfully stabilize depressions and the cycle. But all parties agree that the fault lies deep within the market economy and that if anything can save the day, it must be some form of massive government intervention.

Karl Marx and modern economists blame the market for booms and busts and agree only government can save the day.

For if insufficient spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials? Conversely, it is these industries that really take off in the inflationary boom phases of the business cycle, and not those businesses serving the consumer. An adequate theory of the business cycle, then, must also explain the far greater intensity of booms and busts in the non-consumer goods, or “producers’ goods,” industries.

It was the operations of these commercial banks which, these economists saw, held the key to the mysterious recurrent cycles of expansion and contraction, of boom and bust, that had puzzled observers since the mid-eighteenth century.

banking system is key to understanding the business cycle of booms and busts.

The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate as it does in particular markets: A smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For the banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not. For example, if a bank has 1000 ounces of gold in its vaults, and it issues instantly redeemable warehouse receipts for 2500 ounces of gold, then it clearly has issued 1500 ounces more than it can possibly redeem. But so long as there is no concerted “run” on the bank to cash in these receipts, its warehouse-receipts function on the market as equivalent to gold, and therefore the bank has been able to expand the money supply of the country by 1500 gold ounces.

if sound money were the basis of economy there would be no economic boom/bust, but banks inject credit causing a disruption in the economy. (David Ricardo's view on the banks and sound money)

The result is inflation and a boom within the country. But this inflationary boom, while it proceeds on its merry way, sows the seeds of its own demise. For as English money supply and incomes increase, Englishmen proceed to purchase more goods from abroad. Furthermore, as English prices go up, English goods begin to lose their competitiveness with the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy less at home and more abroad, while foreigners buy less in England and more at home; the result is a deficit in the English balance of payments, with English exports falling sharply behind imports.

inflation has the seeds of deflation and depression sown in it.

But this means that English bank credit money will be, more and more, pyramiding on top of a dwindling gold base in the English bank vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2500 ounces to 4000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation’s banks.

bank credit system removes its own reserve assets showing that the emperor has no clothes, it is backed by nothing.

Why, then, does the next cycle begin? Why do business cycles tend to be recurrent and continuous? Because when the banks have pretty well recovered, and are in a sounder condition, they are then in a confident position to proceed to their natural path of bank credit expansion, and the next boom proceeds on its way, sowing the seeds for the next inevitable bust.

boom and bust cycles never end due to bank credit expansion and inflation sowing the seeds for the next cycle.

Banks can only expand comfortably in unison when a Central Bank exists, essentially a governmental bank, enjoying a monopoly of government business, and a privileged position imposed by government over the entire banking system. It is only when central banking got established that the banks were able to expand for any length of time and the familiar business cycle got underway in the modern world.

private banks are only able to manipulate money supply and perform credit expansion due to government intervention from central bank (the Fed).

So now we see, at last, that the business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.

business cycles due to government intervention not the deficiencies of a free market economy.

Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop. But then government through its central bank stimulates bank credit expansion by expanding central bank liabilities and therefore the cash reserves of all the nation’s commercial banks. The banks then proceed to expand credit and hence the nation’s money supply in the form of check deposits. As the Ricardians saw, this expansion of bank money drives up the prices of goods and hence causes inflation. But, Mises showed, it does something else, and something even more sinister. Bank credit expansion, by pouring new loan funds into the business world, artificially lowers the rate of interest in the economy below its free market level.

Mises, bank credit expansion causes market instability, booms and busts of economic cycle.

As soon as the new bank money filtered through the system and the consumers reestablished their old proportions, it became clear that there were not enough savings to buy all the producers’ goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products.

Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers’ goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not i...

government must stop inflation, cut spending, and not bail out businesses to stop the continual cycles of booms and bust, but this will bring about depression, however it must be endured without government interference to reach a more stable economy.

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off,

Government solves a depression by doing nothing since any intervention makes things worse.

The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

Misesian and Keynsian solutions juxtaposed: no government interference vs. full government interference to save the economy.

1929 was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: A policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States. It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a non-existent free market economy.

Great Depression was caused by expanding bank credit without limits and a departure from the gold standard.

Hoover, not Franklin Roosevelt, was the founder of the policy of the “New Deal”: essentially the massive use of the State to do exactly what Misesian theory would most warn against—to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions. Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression.

Hoover prolonged the Great Depression through government intervention and manipulation of the economy.

The time is ripe—for a rediscovery, a renaissance, of the Mises theory of the business cycle. It can come none too soon; if it ever does, the whole concept of a Council of Economic Advisors would be swept away, and we would see a massive retreat of government from the economic sphere. But for all this to happen, the world of economics, and the public at large, must be made aware of the existence of an explanation of the business cycle that has lain neglected on the shelf for all too many tragic years.

That the order in which a continued increase in the money stream raises the different prices is crucial for an understanding of the effects of inflation was clearly seen more than two hundred years ago by David Hume—and indeed before him by Richard Cantillon. It was in order deliberately to eliminate this effect that Hume assumed as a first approximation that one morning every citizen of a country woke up to find the stock of money in his possession miraculously doubled. Even this would not really lead to an immediate rise of all prices by the same percentage. But it is not what ever really happens. The influx of the additional money into the system always takes place at some particular point. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about. It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances or borrowing for the purpose; it may be spent in the first instance on securities, on investment goods, on wages or on consumer’s goods. It will then in turn be spent on something else by the first recipients of the additional expenditure, and so on. The process will take very different forms according to the initial source or sources of the additional money stream; and all its ramifications will soon be so complex that nobody can ...

inflation and increased prices of goods.