Mises Daily Articles
The Business Cycle Explained in 1755
[From An Essay on Economic Theory, translated by Chantal Saucier, edited by Mark Thornton]
Abstract: When the government's national bank inflates the money supply by increasing the supply of banknotes, it reduces the rate of interest and can increase the price of stocks. This is a corrupt process, and when the notes are redeemed, the price of stocks falls and can result in bank runs and economic chaos. This is now known as the business cycle.
The national Bank of London is composed of a large number of shareholders who elect a board of directors to govern its operations. Their main task consisted in making a yearly distribution of the profits from interest on the money lent against the bank deposits. Later, the public debt was incorporated with it, on which the state pays interest annually.
In spite of such a solid foundation, once the bank had made large advances to the state and the holders of notes were apprehensive that the bank was in difficulties, a run on the bank took place, and holders of notes went in crowds to withdraw money. The same thing happened during the collapse of the South Sea Company in 1720.
The refinements introduced to support the bank and limit its discredit were first to set up a number of clerks to count out the money to those bringing in notes, to pay out large amounts in sixpences and shillings to gain time, and to pay some portion to individual holders who had been waiting all day to be paid.
However, the most considerable sums were paid to friends who took them away and secretly brought them back to the bank only to repeat the same maneuver the next day. In this way, the bank saved its appearance and gained time until the panic abated. But when this did not suffice, the bank opened a stock subscription, engaging trusty and solvent people to join as guarantors of large amounts, in order to maintain the credit and circulation of the bank notes.
It was by this last refinement that the credit of the bank was maintained in 1720 when the South Sea Company collapsed. As soon as it was publicly known that wealthy and powerful people were on the subscription list, the run on the bank ceased and deposits were brought in as usual.
If a Minister of State in England, seeking to lower the interest rate, or for other reasons, increases the price of public stock in London, and if he has enough credit with the directors of the bank to get them to issue a quantity of banknotes without backing (under the obligation of indemnifying them in case of loss), begging them to use these notes to buy several blocks of shares of public stock, this stock's price will increase due to these operations.
And those who have sold stock, seeing that high prices continue, will perhaps decide to buy it back at a higher price than they sold it for, so as not to leave their banknotes idle, believing rumors that the interest rate will fall and that the stock's price will rise further. If several people imitate the agents of the banks and buy this stock, hoping to profit like them, the public funds will increase in price to the point that the minister wishes. And it may be that the bank will cleverly resell at a higher price all the stock purchased at the minister's request, and will not only make a large profit on it, but will retire and cancel all the extraordinary banknotes that were issued.
If the bank alone makes the price of public stock rise by buying it, it will make it fall when it sells it in order to cancel its extraordinary notes. However, many individuals usually follow the agents of the bank in their operations and contribute in keeping the price high. Some of them get caught because they do not understand these operations, in which are found infinite refinements or rather trickery, which lie outside my subject.
It is then evident that a bank, with the complicity of a public administrator, is able to raise and support the price of public stock, and to lower the rate of interest in the state at the pleasure of this administrator. When the steps are taken discreetly, this can pay off the state's debt. But these refinements, which open the door to making large fortunes, are rarely carried out for the sole advantage of the state, and those who take part in them are generally corrupted.
The excess banknotes made and issued on these occasions do not upset the circulation because they are used for the buying and selling of stock. They are not used for household expenses and are not exchanged into silver. But if some panic or unforeseen crisis drove note holders to demand silver from the bank, the bomb would burst and it would be seen that these are dangerous operations.
 Translator's Note: The bank was essentially redeeming its notes with small change in order to delay and discourage redemption.
 Translator's Note: Cantillon is probably referring to Robert Walpole who was in the English cabinet at the time and who would become, in the wake of the scandal, the First Lord of the Treasury, Chancellor of the Exchequer, and Leader of the House of Commons. He was the first "Prime Minister" of England.