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Chapter 12—The Economics of Violent Intervention in the Market (continued)

11. Binary Intervention: Inflation and Business Cycles

A. Inflation and Credit Expansion

     In chapter 11, we depicted the workings of the monetary system of a purely free market. A free money market adopts spe­cie, either gold or silver or both parallel, as the “standard” or money proper. Units of money are simply units of weight of the money-stuff. The total stock of the money commodity increases with new production (mining) and decreases from wear and tear and use in industrial employments. Generally, there will be a gradual secular rise in the money stock, with effects as analyzed above. The wealth of some people will increase and of others will decline, and no social usefulness will accrue from an increased supply of money—in its monetary use. However, an increased stock will raise the social standard of living and well-being by further satisfying nonmonetary demands for the monetary metal.

     Intervention in this money market usually takes the form of issuing pseudo warehouse receipts as money-substitutes. As we saw in chapter 11, demand liabilities such as deposits or paper notes may come into use in a free market, but may equal only the actual value, or weight, of the specie deposited. The demand liabilities are then genuine warehouse receipts, or true money certificates, and they pass on the market as representatives of the actual money, i.e., as money-substitutes. Pseudo warehouse re­ceipts are those issued in excess of the actual weight of specie on deposit. Naturally, their issue can be a very lucrative busi­ness. Looking like the genuine certificates, they serve also as money-substitutes, even though not covered by specie. They are fraudulent, because they promise to redeem in specie at face value, a promise that could not possibly be met were all the de­posit-holders to ask for their own property at the same time. Only the complacency and ignorance of the public permit the situa­tion to continue.[105]

     Broadly, such intervention may be effected either by the gov­ernment or by private individuals and firms in their role as “banks” or money-warehouses. The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called infla­tion.[106] A contraction in the money supply outstanding over any period (aside from a possible net decrease in specie) may be called deflation. Clearly, inflation is the primary event and the primary purpose of monetary intervention. There can be no deflation without an inflation having occurred in some previous period of time. A priori, almost all intervention will be inflationary. For not only must all monetary intervention begin with inflation; the great gain to be derived from inflation comes from the issuer’s putting new money into circulation. The profit is practically cost­less, because, while all other people must either sell goods and services and buy or mine gold, the government or the commer­cial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.

     As happens when new specie enters the market, the issue of “uncovered” money-substitutes also has a diffusion effect: the first receivers of the new money gain the most, the next gain slightly less, etc., until the midpoint is reached, and then each receiver loses more and more as he waits for the new money. For the first individuals’ selling prices soar while buying prices remain almost the same; but later, buying prices have risen while selling prices remain unchanged. A crucial circumstance, however, differenti­ates this from the case of increasing specie. The new paper or new demand deposits have no social function whatever; they do not demonstrably benefit some without injuring others in the market society. The increasing money supply is only a social waste and can only advantage some at the expense of others. And the benefits and burdens are distributed as just outlined: the early-comers gaining at the expense of later-comers. Certainly, the business and consumer borrowers from the bank—its clientele—benefit greatly from the new money (at least in the short run), since they are the ones who first receive it.

     If inflation is any increase in the supply of money not matched by an increase in the gold or silver stock available, the method of inflation just depicted is called credit expansion—the creation of new money-substitutes, entering the economy on the credit market. As will be seen below, while credit expansion by a bank seems far more sober and respectable than outright spending of new money, it actually has far graver consequences for the eco­nomic system, consequences which most people would find es­pecially undesirable. This inflationary credit is called circulating credit, as distinguished from the lending of saved funds—called commodity credit. In this book, the term “credit expansion” will apply only to increases in circulating credit.

     Credit expansion has, of course, the same effect as any sort of inflation: prices tend to rise as the money supply increases. Like any inflation, it is a process of redistribution, whereby the inflators, and the part of the economy selling to them, gain at the expense of those who come last in line in the spending process. This is the charm of inflation—for the beneficiaries—and the rea­son why it has been so popular, particularly since modern bank­ing processes have camouflaged its significance for those losers who are far removed from banking operations. The gains to the in­flators are visible and dramatic; the losses to others hidden and unseen, but just as effective for all that. Just as half the economy are taxpayers and half tax-consumers, so half the economy are inflation-payers and the rest inflation-consumers.

     Most of these gains and losses will be “short-run” or “one-shot”; they will occur during the process of inflation, but will cease after the new monetary equilibrium is reached. The in­flators make their gains, but after the new money supply has been diffused throughout the economy, the inflationary gains and losses are ended. However, as we have seen in chapter 11, there are also permanent gains and losses resulting from inflation. For the new monetary equilibrium will not simply be the old one multiplied in all relations and quantities by the addition to the money supply. This was an assumption that the old “quantity theory” economists made. The valuations of the individuals mak­ing temporary gains and losses will differ. Therefore, each individual will react differently to his gains and losses and alter his relative spending patterns accordingly. Moreover, the new money will form a high ratio to the existing cash balance of some and a low ratio to that of others, and the result will be a variety of changes in spending patterns. Therefore, all prices will not have increased uniformly in the new equilibrium; the purchasing power of the monetary unit has fallen, but not equiproportionally over the entire array of exchange-values. Since some prices have risen more than others, therefore, some people will be per­manent gainers, and some permanent losers, from the inflation.[107]

     Particularly hard hit by an inflation, of course, are the rela­tively “fixed” income groups, who end their losses only after a long period or not at all. Pensioners and annuitants who have contracted for a fixed money income are examples of permanent as well as short-run losers. Life insurance benefits are perma­nently slashed. Conservative anti-inflationists’ complaints about “the widows and orphans” have often been ridiculed, but they are no laughing matter nevertheless. For it is precisely the wid­ows and orphans who bear a main part of the brunt of infla­tion.[108] Also suffering losses are creditors who have already ex­tended their loans and find it too late to charge a purchasing-power premium on their interest rates.

     Inflation also changes the market’s consumption/investment ra­tio. Superficially, it seems that credit expansion greatly increases capital, for the new money enters the market as equivalent to new savings for lending. Since the new “bank money” is appar­ently added to the supply of savings on the credit market, busi­nesses can now borrow at a lower rate of interest; hence infla­tionary credit expansion seems to offer the ideal escape from time preference, as well as an inexhaustible fount of added capital. Actually, this effect is illusory. On the contrary, inflation reduces saving and investment, thus lowering society’s standard of living. It may even cause large-scale capital consumption. In the first place, as we just have seen, existing creditors are injured. This will tend to discourage lending in the future and thereby dis­courage saving-investment. Secondly, as we have seen in chapter 11, the inflationary process inherently yields a purchasing-power profit to the businessman, since he purchases factors and sells them at a later time when all prices are higher. The business­man may thus keep abreast of the price increase (we are here exempting from variations in price increases the terms-of-trade component), neither losing nor gaining from the inflation. But business accounting is traditionally geared to a world where the value of the monetary unit is stable. Capital goods purchased are entered in the asset column “at cost,” i.e., at the price paid for them. When the firm later sells the product, the extra inflationary gain is not really a gain at all; for it must be absorbed in pur­chasing the replaced capital good at a higher price. Inflation, therefore, tricks the businessman: it destroys one of his main sign­posts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubt­edly be tempted to consume out of these profits and thereby un­wittingly consume capital as well. Thus, inflation tends at once to repress saving-investment and to cause consumption of capital.

     The accounting error stemming from inflation has other eco­nomic consequences. The firms with the greatest degree of error will be those with capital equipment bought more preponder­antly when prices were lowest. If the inflation has been going on for a while, these will be the firms with the oldest equipment. Their seemingly great profits will attract other firms into the field, and there will be a completely unjustified expansion of in­vestment in a seemingly high-profit area. Conversely, there will be a deficiency of investment elsewhere. Thus, the error distorts the market’s system of allocating resources and reduces its effec­tiveness in satisfying the consumer. The error will also be greatest in those firms with a greater proportion of capital equipment to product, and similar distorting effects will take place through ex­cessive investment in heavily “capitalized” industries, offset by underinvestment elsewhere.[109]

B. Credit Expansion and the Business Cycle

     We have already seen in chapter 8 what happens when there is net saving-investment: an increase in the ratio of gross invest­ment to consumption in the economy. Consumption expenditures fall, and the prices of consumers’ goods fall. On the other hand, the production structure is lengthened, and the prices of original factors specialized in the higher stages rise. The prices of capital goods change like a lever being pivoted on a fulcrum at its cen­ter; the prices of consumers’ goods fall most, those of first-order capital goods fall less; those of highest-order capital goods rise most, and the others less. Thus, the price differentials between the stages of production all diminish. Prices of original factors fall in the lower stages and rise in the higher stages, and the non­specific original factors (mainly labor) shift partly from the lower to the higher stages. Investment tends to be centered in lengthier processes of production. The drop in price differentials is, as we have seen, equivalent to a fall in the natural rate of interest, which, of course, leads to a corollary drop in the loan rate. After a while the fruit of the more productive techniques arrives; and the real income of everyone rises.

     Thus, an increase in saving resulting from a fall in time pref­erences leads to a fall in the interest rate and another stable equilibrium situation with a longer and narrower production structure. What happens, however, when the increase in invest­ment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? Is this a magic way of expanding the capital structure easily and costlessly, with­out reducing present consumption? Suppose that six million gold ounces are being invested, and four million consumed, in a certain period of time. Suppose, now, that the banks in the economy ex­pand credit and increase the money supply by two million ounces. What are the consequences? The new money is loaned to busi­nesses.[110] These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original fac­tors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the two million new ounces are therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors.

     The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and, as we have seen in chapter 8, lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production struc­ture is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on proj­ects formerly unprofitable. On the free market, investment will always take place first in those projects that satisfy the most urgent wants of the consumers. Then the next most urgent wants are satisfied, etc. The interest rate regulates the temporal order of choice of projects in accordance with their urgency. A lower rate of interest on the market is a signal that more projects can be undertaken profitably. Increased saving on the free market leads to a stable equilibrium of production at a lower rate of interest. But not so with credit expansion: for the original factors now receive increased money income. In the free-market example, to­tal money incomes remained the same. The increased expendi­ture on higher stages was offset by decreased expenditure in the lower stages. The “increased length” of the production struc­ture was compensated by the “reduced width.” But credit expan­sion pumps new money into the production structure: aggregate money incomes increase instead of remaining the same. The pro­duction structure has lengthened, but it has also remained as wide, without contraction of consumption expenditure.

     The owners of the original factors, with their increased money income, naturally hasten to spend their new money. They allo­cate this spending between consumption and investment in ac­cordance with their time preferences. Let us assume that the time-preference schedules of the people remain unchanged. This is a proper assumption, since there is no reason to assume that they have changed because of the inflation. Production now no longer reflects voluntary time preferences. Business has been led by credit expansion to invest in higher stages, as if more savings were available. Since they are not, business has overinvested in the higher stages and underinvested in the lower. Consumers act promptly to re-establish their time preferences—their preferred investment/consumption proportions and price differentials. The differentials will be re-established at the old, higher amount, i.e., the rate of interest will return to its free-market magnitude. As a result, the prices at the higher stages of production will fall drastically, the prices at the lower stages will rise again, and the entire new investment at the higher stages will have to be aban­doned or sacrificed.

     Altering our oversimplified example, which has treated only two stages, we see that the highest stages, believed profitable, have proved to be unprofitable. The pure rate of interest, reflecting consumer desires, is shown to have really been higher all along. The banks’ credit expansion had tampered with that indispens­able “signal”—the interest rate—that tells businessmen how much savings are available and what length of projects will be profit­able. In the free market the interest rate is an indispensable guide, in the time dimension, to the urgency of consumer wants. But bank intervention in the market disrupts this free price and renders entrepreneurs unable to satisfy consumer desires properly or to estimate the most beneficial time structure of production. As soon as the consumers are able, i.e., as soon as the increased money enters their hands, they take the opportunity to re-estab­lish their time preferences and therefore the old differentials and investment-consumption ratios. Overinvestment in the highest stages, and underinvestment in the lower stages are now revealed in all their starkness. The situation is analogous to that of a con­tractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation (the higher stages), with no material left to complete the house.[111] Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.

     It should not be surprising that the market tends to revert to its preferred ratios. The same process, as we have seen, takes place in all prices after a change in the money stock. Increased money always begins in one area of the economy, raising prices there, and filters and diffuses eventually over the whole economy, which then roughly returns to an equilibrium pattern conforming to the value of the money. If the market then tends to return to its preferred price-ratios after a change in the money supply, it should be evident that this includes a return to its preferred sav­ing-investment ratio, reflecting social time preferences.

     It is true, of course, that time preferences may alter in the interim, either for each individual or as a result of the redistri­bution during the change. The gainers may save more or less than the losers would have done. Therefore, the market will not return precisely to the old free-market interest rate and invest­ment/consumption ratio, just as it will not return to its precise pattern of prices. It will revert to whatever the free-market in­terest rate is now, as determined by current time preferences. Some advocates of coercing the market into saving and investing more than it wishes have hailed credit expansion as leading to “forced saving,” thereby increasing the capital-goods structure. But this can happen, not as a direct consequence of credit ex­pansion, but only because effective time preferences have changed in that direction (i.e., time-preference schedules have shifted, or relatively more money is now in the hands of those with low time preferences). Credit expansion may well lead to the oppo­site effect: the gainers may have higher time preferences, in which case the free-market interest rate will be higher than before. Be­cause these effects of credit expansion are completely uncertain and depend on the concrete data of each particular case, it is clearly far more cogent for advocates of forced saving to use the taxation process to make their redistribution.

     The market therefore reacts to a distortion of the free-market interest rate by proceeding to revert to that very rate. The dis­tortion caused by credit expansion deceives businessmen into be­lieving that more savings are available and causes them to malinvest—to invest in projects that will turn out to be unprofitable when consumers have a chance to reassert their true preferences. This reassertion takes place fairly quickly—as soon as owners of factors receive their increased incomes and spend them.

     This theory permits us to resolve an age-old controversy among economists: whether an increase in the money supply can lower the market rate of interest. To the mercantilists—and to the Keynesians—it was obvious that an increased money stock per­manently lowered the rate of interest (given the demand for money). To the classicists it was obvious that changes in the money stock could affect only the value of the monetary unit, and not the rate of interest. The answer is that an increase in the supply of money does lower the rate of interest when it en­ters the market as credit expansion, but only temporarily. In the long run (and this long run is not very “long”), the market re­-establishes the free-market time-preference interest rate and elim­inates the change. In the long run a change in the money stock affects only the value of the monetary unit.

     This process—by which the market reverts to its preferred in­terest rate and eliminates the distortion caused by credit expan­sion—is, moreover, the business cycle! Our analysis therefore per­mits the solution, not only of the theoretical problem of the re­lation between money and interest, but also of the problem that has plagued society for the last century and a half and more—the dread business cycle. And, furthermore, the theory of the busi­ness cycle can now be explained as a subdivision of our general theory of the economy.

     Note the hallmarks of this distortion-reversion process. First, the money supply increases through credit expansion; then busi­nesses are tempted to malinvest—overinvesting in higher-stage and durable production processes. Next, the prices and incomes of original factors increase and consumption increases, and busi­nesses realize that the higher-stage investments have been waste­ful and unprofitable. The first stage is the chief landmark of the “boom”; the second stage—the discovery of the wasteful malin­vestments—is the “crisis.” The depression is the next stage, dur­ing which malinvested businesses become bankrupt, and original factors must suddenly shift back to the lower stages of produc­tion. The liquidation of unsound businesses, the “idle capacity” of the malinvested plant, and the “frictional” unemployment of original factors that must suddenly and en masse shift to lower stages of production—these are the chief hallmarks of the depres­sion stage.

     We have seen in chapter 11 that the major unexplained fea­tures of the business cycle are the mass of error and the concen­tration of error and disturbance in the capital-goods industries. Our theory of the business cycle solves both of these problems. The cluster of error suddenly revealed by entrepreneurs is due to the interventionary distortion of a key market signal—the in­terest rate. The concentration of disturbance in the capital-goods industries is explained by the spur to unprofitable higher-order investments in the boom period. And we have just seen that other characteristics of the business cycle are explained by this theory.

     One point should be stressed: the depression phase is actually the recovery phase. Most people would be happy to keep the boom period, where the inflationary gains are visible and the losses hid­den and obscure. This boom euphoria is heightened by the cap­ital consumption that inflation promotes through illusory account­ing profits. The stages that people complain about are the crisis and depression. But the latter periods, it should be clear, do not cause the trouble. The trouble occurs during the boom, when malinvestments and distortions take place; the crisis-depression phase is the curative period, after people have been forced to rec­ognize the malinvestments that have occurred. The depression period, therefore, is the necessary recovery period; it is the time when bad investments are liquidated and mistaken entrepreneurs leave the market—the time when “consumer sovereignty” and the free market reassert themselves and establish once again an econ­omy that benefits every participant to the maximum degree. The depression period ends when the free-market equilibrium has been restored and expansionary distortion eliminated.

     It should be clear that any governmental interference with the depression process can only prolong it, thus making things worse from almost everyone’s point of view. Since the depression process is the recovery process, any halting or slowing down of the process impedes the advent of recovery. The depression readjustments must work themselves out before recovery can be complete. The more these readjustments are delayed, the longer the depression will have to last, and the longer complete recovery is postponed. For example, if the government keeps wage rates up, it brings about permanent unemployment. If it keeps prices up, it brings about unsold surplus. And if it spurs credit expansion again, then new malinvestment and later depressions are spawned.

     Many nineteenth-century economists referred to the business cycle in a biological metaphor, likening the depression to a pain­ful but necessary curative of the alcoholic or narcotic jag which is the boom, and asserting that any tampering with the depres­sion delays recovery. They have been widely ridiculed by present-day economists. The ridicule is misdirected, however, for the bi­ological analogy is in this case correct.

     One obvious conclusion from our analysis is the absurdity of the “underconsumptionist” remedies for depression—the idea that the crisis is caused by underconsumption and that the way to cure the depression is to stimulate consumption expenditures. The re­verse is clearly the truth. What has brought about the crisis is precisely the fact that entrepreneurial investment erroneously an­ticipated greater savings, and that this error is revealed by con­sumers’ re-establishing their desired proportion of consumption. “Overconsumption” or “undersaving” has brought about the cri­sis, although it is hardly fair to pin the guilt on the consumer, who is simply trying to restore his preferences after the market has been distorted by bank credit. The only way to hasten the curative process of the depression is for people to save and invest more and consume less, thereby finally justifying some of the mal­investments and mitigating the adjustments that have to be made.

     One problem has been left unexplained. We have seen that the reversion period is short and that factor incomes increase rather quickly and start restoring the free-market consumption/saving ratios. But why do booms, historically, continue for several years? What delays the reversion process? The answer is that as the boom begins to peter out from an injection of credit expansion, the banks inject a further dose. In short, the only way to avert the onset of the depression-adjustment process is to continue inflating money and credit. For only continual doses of new money on the credit market will keep the boom going and the new stages profit­able. Furthermore, only ever increasing doses can step up the boom, can lower interest rates further, and expand the produc­tion structure, for as the prices rise, more and more money will be needed to perform the same amount of work. Once the credit expansion stops, the market ratios are re-established, and the seem­ingly glorious new investments turn out to be malinvestments, built on a foundation of sand.

     How long booms can be kept up, what limits there are to booms in different circumstances, will be discussed below. But it is clear that prolonging the boom by ever larger doses of credit expan­sion will have only one result: to make the inevitably ensuing depression longer and more grueling. The larger the scope of mal­investment and error in the boom, the greater and longer the task of readjustment in the depression. The way to prevent a de­pression, then, is simple: avoid starting a boom. And to avoid starting a boom all that is necessary is to pursue a truly free-mar­ket policy in money, i.e., a policy of 100-percent specie reserves for banks and governments.

     Credit expansion always generates the business cycle process, even when other tendencies cloak its workings. Thus, many peo­ple believe that all is well if prices do not rise or if the actually recorded interest rate does not fall. But prices may well not rise because of some counteracting force—such as an increase in the supply of goods or a rise in the demand for money. But this does not mean that the boom-depression cycle fails to occur. The es­sential processes of the boom—distorted interest rates, malinvest­ments, bankruptcies, etc.—continue unchecked. This is one of the reasons why those who approach business cycles from a statistical point of view and try in that way to arrive at a theory are in hopeless error. Any historical-statistical fact is a complex resultant of many causal influences and cannot be used as a simple element with which to construct a causal theory. The point is that credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle. Similarly, credit expansion does not necessarily lower the interest rate be­low the rate previously recorded; it lowers the rate below what it would have been in the free market and thus creates distor­tion and malinvestment. Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate. An increase in prices, as we have seen, generates a positive purchasing-power component in the natural interest rate, i.e., the rate of return earned by businessmen on the market. In the free market this would quickly be reflected in the loan rate, which, as we have seen above, is completely de­pendent on the natural rate. But a continual influx of circulat­ing credit prevents the loan rate from catching up with the nat­ural rate, and thereby generates the business-cycle process.[112] A further corollary of this bank-created discrepancy between the loan rate and the natural rate is that creditors on the loan mar­ket suffer losses for the benefit of their debtors: the capitalists on the stock market or those who own their own businesses. The latter gain during the boom by the differential between the loan rate and the natural rate, while the creditors (apart from banks, which create their own money) lose to the same extent.

     After the boom period is over, what is to be done with the malinvestments? The answer depends on their profitability for further use, i.e., on the degree of error that was committed. Some malinvestments will have to be abandoned, since their earnings from consumer demand will not even cover the current costs of their operation. Others, though monuments of failure, will be able to yield a profit over current costs, although it will not pay to replace them as they wear out. Temporarily working them ful­fills the economic principle of always making the best of even a bad bargain.

     Because of the malinvestments, however, the boom always leads to general impoverishment, i.e., reduces the standard of living be­low what it would have been in the absence of the boom. For the credit expansion has caused the squandering of scarce resources and scarce capital. Some resources have been completely wasted, and even those malinvestments that continue in use will satisfy consumers less than would have been the case without the credit expansion.

C. Secondary Developments of the Business Cycle

     In the previous section we have presented the basic process of the business cycle. This process is often accentuated by other or “secondary” developments induced by the cycle. Thus, the ex­panding money supply and rising prices are likely to lower the demand for money. Many people begin to anticipate higher prices and will therefore dishoard. The lowered demand for money raises prices further. Since the impetus to expansion comes first in ex­penditure on capital goods and later in consumption, this “sec­ondary effect” of a lower demand for money may take hold first in producers’-goods industries. This lowers the price-and-profit differentials further and hence widens the distance that the rate of interest will fall below the free-market rate during the boom. The effect is to aggravate the need for readjustment during the depression. The adjustment would cause some fall in the prices of producers’ goods anyway, since the essence of the adjustment is to raise price differentials. The extra distortion requires a steeper fall in the prices of producers’ goods before recovery is completed.

     As a matter of fact, the demand for money generally rises at the beginning of an inflation. People are accustomed to thinking of the value of the monetary unit as inviolate and of prices as remaining at some “customary” level. Hence, when prices first be­gin to rise, most people believe this to be a purely temporary de­velopment, with prices soon due to recede. This belief mitigates the extent of the price rise for a time. Eventually, however, peo­ple realize that credit expansion has continued and undoubtedly will continue, and their demand for money dwindles, becoming lower than the original level.

     After the crisis arrives and the depression begins, various sec­ondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation—a contraction in the supply of money. The deflation causes a fur­ther decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit con­traction by the banks—and this is almost always the case—this will have the beneficial effect of speeding up the depression-adjust­ment process. For credit contraction creates higher price differ­entials. And the essence of the required adjustment is to return to higher price differentials, i.e., a higher “natural” rate of in­terest. Furthermore, deflation will hasten adjustment in yet an­other way: for the accounting error of inflation is here reversed, and businessmen will think their losses are more, and profits less, than they really are. Hence, they will save more than they would have with correct accounting, and the increased saving will speed adjustment by supplying some of the needed deficiency of savings.

     It may well be true that the deflationary process will overshoot the free-market equilibrium point and raise price differentials and the interest rate above it. But if so, no harm will be done, since a credit contraction can create no malinvestments and there­fore does not generate another boom-bust cycle.[113] And the mar­ket will correct the error rapidly. When there is such excessive contraction, and consumption is too high in relation to savings, the money income of businessmen is reduced, and their spending on factors declines—especially in the higher orders. Owners of original factors, receiving lower incomes, will spend less on con­sumption, price differentials and the interest rate will again be lowered, and the free-market consumption/ investment ratios will be speedily restored.

     Just as inflation is generally popular for its narcotic effect, de­flation is always highly unpopular for the opposite reason. The contraction of money is visible; the benefits to those whose buy­ing prices fall first and who lose money last remain hidden. And the illusory accounting losses of deflation make businesses believe that their losses are greater, or profits smaller, than they actually are, and this will aggravate business pessimism.

     It is true that deflation takes from one group and gives to an­other, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of orig­inal factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.[114]

     Some may object that deflation “causes” unemployment. How­ever, as we have seen above, deflation can lead to continuing un­employment only if the government or the unions keep wage rates above the discounted marginal value products of labor. If wage rates are allowed to fall freely, no continuing unemploy­ment will occur.

     Finally, deflationary credit contraction is, necessarily, severely limited. Whereas credit can expand (barring various economic limits to be discussed below) virtually to infinity, circulating credit can contract only as far down as the total amount of specie in circulation. In short, its maximum possible limit is the eradica­tion of all previous credit expansion.

     The business-cycle analysis set forth here has essentially been that of the “Austrian” School, originated and developed by Lud­wig von Mises and some of his students.[115] A prominent criticism of this theory is that it “assumes the existence of full employ­ment” or that its analysis holds only after “full employment” has been attained. Before that point, say the critics, credit expansion will beneficently put these factors to work and not generate fur­ther malinvestments or cycles. But, in the first place, inflation will put no unemployed factors to work unless their owners, though holding out for a money price higher than their mar­ginal value product, are blindly content to accept the necessarily lower real price when it is camouflaged as a rise in the “cost of living.” And credit expansion generates further cycles whether or not there are unemployed factors. It creates more distortions and malinvestments, delays indefinitely the process of recovery from the previous boom, and makes necessary an eventually far more grueling recovery to adjust to the new malinvestments as well as to the old. If idle capital goods are now set to work, this “idle capacity” is the hangover effect of previous wasteful malinvest­ments, and hence is really submarginal and not worth bringing into production. Putting the capital to work again will only re­double the distortions.[116]

D. The Limits of Credit Expansion

     Having investigated the consequences of credit expansion, we must discuss the important question: If fractional-reserve banking is legal, are there any natural limits to credit expansion by the banks? The one basic limit, of course, is the necessity of the banks to redeem their money-substitutes on demand. Under a gold or silver standard, they must redeem in specie; under a government fiat paper standard (see below), the banks have to redeem in government paper. In any case, they must redeem in standard money or its virtual equivalent. Therefore, every frac­tional reserve bank depends for its very existence on persuading the public—specifically its clients—that all is well and that it will be able to redeem its notes or deposits whenever the clients de­mand. Since this is palpably not the case, the continuance of con­fidence in the banks is something of a psychological marvel.[117] It is certain, at any rate, that a wider knowledge of praxeology among the public would greatly weaken confidence in the bank­ing system. For the banks are in an inherently weak position. Let just a few of their clients lose confidence and begin to call on the banks for redemption, and this will precipitate a scramble by other clients to make sure that they get their money while the banks’ doors are still open. The obvious—and justifiable—panic of the banks should any sort of “run” develop encourages other clients to do the same and aggravates the run still further. At any rate, runs on banks can wreak havoc, and, of course, if pursued consistently, could close every bank in the country in a few days.[118]

     Runs, therefore, and the constant underlying threat of their oc­currence, are one of the prime limits to credit expansion. Runs often develop during a business cycle crisis, when debts are be­ing defaulted and failures become manifest. Runs and the fear of runs help to precipitate deflationary credit contraction.

     Runs may be an ever-present threat, but, as effective limita­tions, they are not generally active. When they do occur, they usually wreck the banks. The fact that a bank is in existence at all signifies that a run has not developed. A more active, everyday limitation is the relatively narrow range of a bank’s clientele. The clientele of a bank consists of those people willing to hold its deposits or notes (its money-substitutes) in lieu of money proper. It is an empirical fact, in almost all cases, that one bank does not have the patronage of all people in the market society or even of all those who prefer to use bank money rather than specie. It is obvious that the more banks exist, the more restricted will be the clientele of any one bank. People decide which bank to use on many grounds; reputation for integrity, friendliness of service, price of service, and convenience of location may all play a part.

     How does the narrow range of a bank’s clientele limit its potentiality for credit expansion? The newly issued money-substi­tutes are, of course, loaned to a bank’s clients. The client then spends the new money on goods and services. The new money begins to be diffused throughout the society. Eventually—usually very quickly—it is spent on the goods or services of people who use a different bank. Suppose that the Star Bank has expanded credit; the newly issued Star Bank’s notes or deposits find their way into the hands of Mr. Jones, who uses the City Bank. Two alternatives may occur, either of which has the same economic effect: (a) Jones accepts the Star Bank’s notes or deposits, and de­posits them in the City Bank, which calls on the Star Bank for redemption; or (b) Jones refuses to accept the Star Bank’s notes and insists that the Star client—say Mr. Smith—who bought some­thing from Jones, redeem the note himself and pay Jones in ac­ceptable standard money.

     Thus, while gold or silver is acceptable throughout the mar­ket, a bank’s money-substitutes are acceptable only to its own clientele. Clearly, a single bank’s credit expansion is limited, and this limitation is stronger (a) the narrower the range of its cli­entele, and (b) the greater its issue of money-substitutes in rela­tion to that of competing banks. In illustration of the first point, let us assume that each bank has only one client. Then it is ob­vious that there will be very little room for credit expansion. At the opposite extreme, if one bank is used by everybody in the economy, there will be no demands for redemption resulting from its clients’ purchasing from nonclients. It is obvious that, ceteris paribus, a numerically smaller clientele is more restrictive of credit expansion.

     As regards the second point, the greater the degree of relative credit expansion by any one bank, the sooner will the day of re­demption—and potential bankruptcy—be at hand. Suppose that the Star Bank expands credit, while none of the competing banks do. This means that the Star Bank’s clientele have added con­siderably to their cash balances; as a result the marginal utility to them of each unit of money to hold declines, and they are im­pelled to spend a great proportion of the new money. Some of this increased spending will be on one another’s goods and serv­ices, but it is clear that the greater the credit expansion, the greater will be the tendency for their spending to “spill over” onto the goods and services of nonclients. This tendency to spill over, or “drain,” is greatly enhanced when increased spending by clients on the goods and services of other clients raises their prices. In the meanwhile, the prices of the goods sold by nonclients re­main the same. As a consequence, clients are impelled to buy more from nonclients and less from one another; while noncli­ents buy less from clients and more from one another. The re­sult is an “unfavorable” balance of trade from clients to noncli­ents.[119]  It is clear that this tendency of money to seek a uniform level of exchange value throughout the entire market is an ex­ample of the process by which new money (in this case, new money-substitutes) is diffused through the market. The greater the relative credit expansion by the bank, then, the greater and more rapid will be the drain and consequent pressure on an ex­panding bank for redemption.

     The purpose of banks’ keeping any specie reserves in their vaults (assuming no legal reserve requirements) now becomes manifest. It is not to meet bank runs—since no fractional-reserve bank can be equipped to withstand a run. It is to meet the de­mands for redemption which will inevitably come from noncli­ents.

     Mises has brilliantly shown that a subdivision of this process was discovered by the British Currency School and by the clas­sical “international trade” theorists of the nineteenth century. These older economists assumed that all the banks in a certain region or country expanded credit together. The result was a rise in the prices of goods produced in that country. A further re­sult was an “unfavorable” balance of trade, i.e., an outflow of standard specie to other countries. Since other countries did not patronize the expanding country’s banks, the consequence was a “specie drain” from the expanding country and increased pres­sure for redemption on its banks.

     Like all parts of the overstressed and overelaborated theory of “international trade,” this analysis is simply a special subdivision of “general” economic theory. And cataloging it as “international trade” theory, as Mises has shown, underestimates its true signif­icance.[120][121]

     Thus, the more freely competitive and numerous are the banks, the less they will be able to expand fiduciary media, even if they are left free to do so. As we have noted in chapter 11, such a system is known as “free banking.”[122] A major objection to this analysis of free banking has been the problem of bank “cartels.” If banks get together and agree to expand their credits simulta­neously, the clientele limitation vis-à-vis competing banks will be removed, and the clientele of each bank will, in effect, increase to include all bank users. Mises points out, however, that the sounder banks with higher fractional reserves will not wish to lose the goodwill of their own clients and risk bank runs by en­tering into collusive agreements with weaker banks.[123] This con­sideration, while placing limits on such agreements, does not rule them out altogether. For, after all, no fractional-reserve banks are really sound, and if the public can be led to believe that, say, an 80-percent-specie reserve is sound, it can believe the same about 60-percent- or even 10-percent-reserve banks. Indeed, the fact that the weaker banks are allowed by the public to exist at all demonstrates that the more conservative banks may not lose much good will by agreeing to expand with them.

     As Mises has demonstrated, there is no question that, from the point of view of opponents of inflation and credit expansion, free banking is superior to a central banking system (see below). But, as Amasa Walker stated:

Much has been said, at different times, of the desirableness of free banking. Of the propriety and rightfulness of allowing any person who chooses to carry on banking, as freely as farming or any other branch of business, there can be no doubt. But, while banking, as at present, means the issuing of inconvertible paper, the more it is guarded and restricted the better. But when such issues are entirely forbidden, and only notes equivalent to certificates of so much coin are issued, banking may be as free as brokerage. The only thing to be secured would be that no issues should be made except upon specie in hand.[124]

[105]Although it has obvious third-person effects, this type of intervention is essentially binary because the issuer, or intervener, gains at the ex­pense of individual holders of legitimate money. The “lines of force” radiate from the interveners to each of those who suffer losses.

[106]Inflation, in this work, is explicitly defined to exclude increases in the stock of specie. While these increases have such similar effects as rais­ing the prices of goods, they also differ sharply in other effects: (a) simple increases in specie do not constitute an intervention in the free market, penalizing one group and subsidizing another; and (b) they do not lead to the processes of the business cycle.

[107]Cf. Mises, Theory of Money and Credit, pp. 140–42.

[108]The avowed goal of Keynes’ inflationist program was the “euthanasia of the rentier.” Did Keynes realize that he was advocating the not-so-­merciful annihilation of some of the most unfit-for-labor groups in the entire population—groups whose marginal value productivity consisted almost exclusively in their savings? Keynes, General Theory, p. 376.

[109]For an interesting discussion of some aspects of the accounting error, see W.T. Baxter, “The Accountant’s Contribution to the Trade Cycle,” Economica, May, 1955, pp.  99–112. Also see Mises, Theory of Money and Credit, pp. 202–04; and Human Action, pp. 546f.

[110]To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.

[111]See Mises, Human Action, p. 557.

[112]Since Knut Wicksell is one of the fathers of this business-cycle approach, it is important to stress that our usage of “natural rate” differs from his. Wicksell’s “natural rate” was akin to our “free-market rate”; our “natural rate” is the rate of return earned by businesses on the exist­ing market without considering loan interest. It corresponds to what has been misleadingly called the “normal profit rate,” but is actually the basic rate of interest. See chapter 6 above.

[113]If some readers are tempted to ask why credit contraction will not lead to the opposite type of malinvestment to that of the boom—overinvest­ment in lower-order capital goods and underinvestment in higher-order goods—the answer is that there is no arbitrary choice open of investing in higher-order or lower-order goods. Increased investment must be made in the higher-order goods—in lengthening the structure of production. A decreased amount of investment simply cuts down on higher-order in­vestment. There will thus be no excess of investment in the lower or­ders, but simply a shorter structure than would otherwise be the case. Contraction, unlike expansion, does not create positive malinvestments.

[114]If the economy is on a gold or silver standard, then many advocates of a free market will argue for credit contraction for the following additional reasons: (a) to preserve the principle of paying one’s contractual obligations and (b) to punish the banks for their expansion and force them back toward a 100-percent-specie reserve policy.

[115]Mises first presented the “Austrian theory” in a notable section of his Theory of Money and Credit, pp. 346–66. For a more developed statement, see his Human Action, pp. 547–83. For F.A. Hayek’s important contributions, see especially his Prices and Production, and also his Monetary Theory and the Trade Cycle (London: Jonathan Cape, 1933), and Profits, Interest, and Investment. Other works in the Misesian tradition include Robbins, The Great Depression, and Fritz Machlup, The Stock Market, Credit, and Capital Formation (New York: Macmillan & Co., 1940).

[116]See Mises, Human Action, pp. 577–78; and Hayek, Prices and Produc­tion, pp. 96–99.

[117]Perhaps one reason for continuing confidence in the banking system is that people generally believe that fraud is prosecuted by the government and that, therefore, any practice not so prosecuted must be sound. Governments, indeed (as we shall see below), always go out of their way to bolster the banking system.

[118]All this, of course, assumes no further government intervention in bank­ing than permitting fractional-reserve banking. Since the advent of de­posit “insurance” during the New Deal, for example, the bank-run lim­itation has been virtually eliminated by this act of special privilege.

[119]In the consolidated balance of payments of the clients, money income from sales to nonclients (exports) will decline, and money expenditures on the goods and services of nonclients (imports) will increase. The excess cash balances of the clients are transferred to nonclients.

[120]Older economists also distinguished an “internal drain” as well as the “external drain,” but included in the former only the drain from bank users to those who insist on standard money.

[121]See Human Action, pp. 434–35.

[122]For various views on free and central banking, see Vera C. Smith, The Rationale of Central Banking (London: P.S. King and Son, 1936).

[123]Mises, Human Action, p. 444.

[124]Amasa Walker, Science of Wealth, pp. 230–31.

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