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2. Monetary Stabilization and Cyclical Policy (1928)

Part B: Cyclical Policy to Eliminate Economic Fluctuations


1. Currency School’s Contribution

“Stabilization” of the purchasing power of the monetary unit would also lead, at the same time, to the ideal of an economy without any changes. In the stationary economy there would be no “ups” and “downs” of business. Then, the sequence of events would flow smoothly and steadily. Then, no unforeseen event would interrupt the provisioning of goods. Then, the acting individual would experience no disillusionment because events did not develop as he had assumed in planning his affairs to meet future demands.

First, we have seen that this ideal cannot be realized. Second, we have seen that this ideal is generally proposed as a goal only because the problems involved in the formation of purchasing power have not been thought through completely. Finally, we have seen that even if a stationary economy could actually be realized, it would certainly not accomplish what had been expected. Yet neither these facts nor the limiting of monetary policy to the maintenance of a “pure” gold standard mean that the political slogan, “Eliminate the business cycle,” is without value.

It is true that some authors, who dealt with these problems, had a rather vague idea that the “stabilization of the price level” was the way to attain the goals they set for cyclical policy. Yet cyclical policy was not completely spent on fruitless attempts to fix the purchasing power of money. Witness the fact that steps were undertaken to curb the boom through banking policy, and thus to prevent the decline, which inevitably follows the upswing, from going as far as it would if matters were allowed to run their course. These efforts—undertaken with enthusiasm at a time when people did not realize that anything like stabilization of monetary value would ever be conceived of and sought after—led to measures that had far-reaching consequences.

We should not forget for a moment the contribution which the Currency School made to the clarification of our problem. Not only did it contribute theoretically and scientifically but it contributed also to practical policy. The recent theoretical treatment of the problem—in the study of events and statistical data and in politics—rests entirely on the accomplishments of the Currency School. We have not surpassed Lord Overstone28 so far as to be justified in disparaging his achievement.

Many modern students of cyclical movements are contemptuous of theory—not only of this or that theory but of all theories—and profess to let the facts speak for themselves. The delusion that theory must be distilled from the results of an impartial investigation of facts is more popular in cyclical theory than in any other field of economics. Yet, nowhere else is it clearer that there can be no understanding of the facts without theory.

Certainly it is no longer necessary to expose once more the errors in logic of the Historical-Empirical-Realistic approach to the “social sciences.”29 Only recently has this task been most thoroughly undertaken once more by competent scholars. Nevertheless, we continually encounter attempts to deal with the business cycle problem while presumably rejecting theory.

In taking this approach one falls prey to a delusion which is incomprehensible. It is assumed that data on economic fluctuations are given clearly, directly and in a way that cannot be disputed. Thus it remains for science merely to interpret these fluctuations—and for the art of politics simply to find ways and means to eliminate them.

2. Early Trade Cycle Theories

All business establishments do well at times and badly at others. There are times when the entrepreneur sees his profits increase daily more than he had anticipated and when, emboldened by these “windfalls,” he proceeds to expand his operations. Then, due to an abrupt change in conditions, severe disillusionment follows this upswing, serious losses materialize, long established firms collapse, until widespread pessimism sets in which may frequently last for years. Such were the experiences which had already been forced on the attention of the businessman in capitalistic economies, long before discussions of the crisis problem began to appear in the literature. The sudden turn from the very sharp rise in prosperity—at least what appeared to be prosperity—to a very severe drop in profit opportunities was too conspicuous not to attract general attention. Even those who wanted to have nothing to do with the business world's “worship of filthy lucre” could not ignore the fact that people who were, or had been considered, rich yesterday were suddenly reduced to poverty, that factories were shut down, that construction projects were left uncompleted, and that workers could not find work. Naturally, nothing concerned the businessman more intimately than this very problem.

If an entrepreneur is asked what is going on here—leaving aside changes in the prices of individual commodities due to recognizable causes—he may very well reply that at times the entire “price level” tends upward and then at other times it tends downward. For inexplicable reasons, he would say, conditions arise under which it is impossible to dispose of all commodities, or almost all commodities, except at a loss. And what is most curious is that these depressing times always come when least expected, just when all business had been improving for some time so that people finally believed that a new age of steady and rapid progress was emerging.

Eventually, it must have become obvious to the more keenly thinking businessman that the genesis of the crisis should be sought in the preceding boom. The scientific investigator, whose view is naturally focused on the longer period, soon realized that economic upswings and downturns alternated with seeming regularity. Once this was established, the problem was halfway exposed and scientists began to ask questions as to how this apparent regularity might be explained and understood.

Theoretical analysis was able to reject, as completely false, two attempts to explain the crisis—the theories of general overproduction and of underconsumption. These two doctrines have disappeared from serious scientific discussion. They persist today only outside the realm of science—the theory of general overproduction, among the ideas held by the average citizen; and the underconsumption theory, in Marxist literature.

It was not so easy to criticize a third group of attempted explanations, those which sought to trace economic fluctuations back to periodic changes in natural phenomena affecting agricultural production. These doctrines cannot be reached by theoretical inquiry alone. Conceivably such events may occur and reoccur at regular intervals. Whether this actually is the case can be shown only by attempts to verify the theory through observation. So far, however, none of these “weather theories”30 has successfully passed this test.

A whole series of a very different sort of attempts to explain the crisis are based on a definite irregularity in the psychological and intellectual talents of people. This irregularity is expressed in the economy by a change from confidence over the future, which inspires the boom, to despondency, which leads to the crisis and to stagnation of business. Or else this irregularity appears as a shift from boldly striking out in new directions to quietly following along already well-worn paths.

What should be pointed out about these doctrines and about the many other similar theories based on psychological variations is, first of all, that they do not explain. They merely pose the problem in a different way. They are not able to trace the change in business conditions back to a previously established and identified phenomenon. From the periodical fluctuations in psychological and intellectual data alone, without any further observation concerning the field of labor in the social or other sciences, we learn that such economic shifts as these may also be conceived of in a different way. So long as the course of such changes appears plausible only because of economic fluctuations between boom and bust, psychological and other related theories of the crisis amount to no more than tracing one unknown factor back to something else equally unknown.

3. The Circulation Credit Theory

Of all the theories of the trade cycle, only one has achieved and retained the rank of a fully-developed economic doctrine. That is the theory advanced by the Currency School, the theory which traces the cause of changes in business conditions to the phenomenon of circulation credit. All other theories of the crisis, even when they try to differ in other respects from the line of reasoning adopted by the Currency School, return again and again to follow in its footsteps. Thus, our attention is constantly being directed to observations which seem to corroborate the Currency School's interpretation.

In fact, it may be said that the Circulation Credit Theory of the Trade Cycle31 is now accepted by all writers in the field and that the other theories advanced today aim only at explaining why the volume of circulation credit granted by the banks varies from time to time. All attempts to study the course of business fluctuations empirically and statistically, as well as all efforts to influence the shape of changes in business conditions by political action, are based on the Circulation Credit Theory of the Trade Cycle.

To show that an investigation of business cycles is not dealing with an imaginary problem, it is necessary to formulate a cycle theory that recognizes a cyclical regularity of changes in business conditions. If we could not find a satisfactory theory of cyclical changes, then the question would remain as to whether or not each individual crisis arose from a special cause which we would have to track down first. Originally, economics approached the problem of the crisis by trying to trace all crises back to specific “visible” and “spectacular” causes such as war, cataclysms of nature, adjustments to new economic data—for example, changes in consumption and technology, or the discovery of easier and more favorable methods of production. Crises which could not be explained in this way became the specific “problem of the crisis.”

Neither the fact that unexplained crises still recur again and again nor the fact that they are always preceded by a distinct boom period is sufficient to prove with certainty that the problem to be dealt with is a unique phenomenon originating from one specific cause. Recurrences do not appear at regular intervals. And it is not hard to believe that the more a crisis contrasts with conditions in the immediately preceding period, the more severe it is considered to be. It might be assumed, therefore, that there is no specific “problem of the crisis” at all, and that the still unexplained crises must be explained by various special causes somewhat like the “crisis” which Central European agriculture has faced since the rise of competition from the tilling of richer soil in Eastern Europe and overseas, or the “crisis” of the European cotton industry at the time of the American Civil War. What is true of the crisis can also be applied to the boom. Here again, instead of seeking a general boom theory we could look for special causes for each individual boom.

Neither the connection between boom and bust nor the cyclical change of business conditions is a fact that can be established independent of theory. Only theory, business cycle theory, permits us to detect the wavy outline of a cycle in the tangled confusion of events.32


1. The Banking School Fallacy

If notes are issued by the banks, or if bank deposits subject to check or other claim are opened, in excess of the amount of money kept in the vaults as cover, the effect on prices is similar to that obtained by an increase in the quantity of money. Since these fiduciary media, as notes and bank deposits not backed by metal are called, render the service of money as safe and generally accepted, payable on demand monetary claims, they may be used as money in all transactions. On that account, they are genuine money substitutes. Since they are in excess of the given total quantity of money in the narrower sense, they represent an increase in the quantity of money in the broader sense.

The practical significance of these undisputed and indisputable conclusions in the formation of prices is denied by the Banking School with its contention that the issue of such fiduciary media is strictly limited by the demand for money in the economy. The Banking School doctrine maintains that if fiduciary media are issued by the banks only to discount short-term commodity bills, then no more would come into circulation than were “needed” to liquidate the transactions. According to this doctrine, bank management could exert no influence on the volume of the commodity transactions activated. Purchases and sales from which short-term commodity bills originate would, by this very transaction, already have brought into existence paper credit which can be used, through further negotiation, for the exchange of goods and services. If the bank discounts the bill and, let us say, issues notes against it, that is, according to the Banking School, a neutral transaction as far as the market is concerned. Nothing more is involved than replacing one instrument which is technically less suitable for circulation, the bill of exchange, with a more suitable one, the note. Thus, according to this School, the effect of the issue of notes need not be to increase the quantity of money in circulation. If the bill of exchange is retired at maturity, then notes would flow back to the bank and new notes could enter circulation again only when new commodity bills came into being once more as a result of new business.

The weak link in this well-known line of reasoning lies in the assertion that the volume of transactions completed, as sales and purchases from which commodity bills can derive, is independent of the behavior of the banks. If the banks discount at a lower, rather than at a higher, interest rate, then more loans are made. Enterprises which are unprofitable at 5 percent, and hence are not undertaken, may be profitable at 4 percent. Therefore, by lowering the interest rate they charge, banks can intensify the demand for credit. Then, by satisfying this demand, they can increase the quantity of fiduciary media in circulation. Once this is recognized, the Banking Theory's only argument, that prices are not influenced by the issue of fiduciary media, collapses.

One must be careful not to speak simply of the effects of credit in general on prices, but to specify clearly the effects of “increased credit” or “credit expansion.” A sharp distinction must be made between (1) credit which a bank grants by lending its own funds or funds placed at its disposal by depositors, which we call “commodity credit,” and (2) that which is granted by the creation of fiduciary media, i.e., notes and deposits not covered by money, which we call “circulation credit.”33 It is only through the granting of circulation credit that the prices of all commodities and services are directly affected.

If the banks grant circulation credit by discounting a three month bill of exchange, they exchange a future good—a claim payable in three months—for a present good that they produce out of nothing. It is not correct, therefore, to maintain that it is immaterial whether the bill of exchange is discounted by a bank of issue or whether it remains in circulation, passing from hand to hand. Whoever takes the bill of exchange in trade can do so only if he has the resources. But the bank of issue discounts by creating the necessary funds and putting them into circulation. To be sure, the fiduciary media flow back again to the bank at expiration of the note. If the bank does not give the fiduciary media out again, precisely the same consequences appear as those which come from a decrease in the quantity of money in its broader sense.

2. Early Effects of Credit Expansion

The fact that in the regular course of banking operations the banks issue fiduciary media only as loans to producers and merchants means that they are not used directly for purposes of consumption.34 Rather, these fiduciary media are used first of all for production, that is to buy factors of production and pay wages. The first prices to rise, therefore, as a result of an increase of the quantity of money in the broader sense, caused by the issue of such fiduciary media, are those of raw materials, semimanufactured products, other goods of higher orders, and wage rates. Only later do the prices of goods of the first order [consumers’ goods] follow. Changes in the purchasing power of a monetary unit, brought about by the issue of fiduciary media, follow a different path and have different accompanying social side effects from those produced by a new discovery of precious metals or by the issue of paper money. Still in the last analysis, the effect on prices is similar in both instances.

Changes in the purchasing power of the monetary unit do not directly affect the height of the rate of interest. An indirect influence on the height of the interest rate can take place as a result of the fact that shifts in wealth and income relationships, appearing as a result of the change in the value of the monetary unit, influence savings and, thus, the accumulation of capital. If a depreciation of the monetary unit favors the wealthier members of society at the expense of the poorer, its effect will probably be an increase in capital accumulation since the well-to-do are the more important savers. The more they put aside, the more their incomes and fortunes will grow.

If monetary depreciation is brought about by an issue of fiduciary media, and if wage rates do not promptly follow the increase in commodity prices, then the decline in purchasing power will certainly make this effect much more severe. This is the “forced savings” which is quite properly stressed in recent literature.35 However, three things should not be forgotten. First, it always depends upon the data of the particular case whether shifts of wealth and income, which lead to increased saving, are actually set in motion. Second, under circumstances which need not be discussed further here, by falsifying economic calculation, based on monetary bookkeeping calculations, a very substantial devaluation can lead to capital consumption (such a situation did take place temporarily during the recent inflationary period). Third, as advocates of inflation through credit expansion should observe, any legislative measure which transfers resources to the “rich” at the expense of the “poor” will also foster capital formation.

Eventually, the issue of fiduciary media in such manner can also lead to increased capital accumulation within narrow limits and, hence, to a further reduction of the interest rate. In the beginning, however, an immediate and direct decrease in the loan rate appears with the issue of fiduciary media, but this immediate decrease in the loan rate is distinct in character and degree from the later reduction. The new funds offered on the money market by the banks must obviously bring pressure to bear on the rate of interest. The supply and demand for loan money were adjusted at the interest rate prevailing before the issue of any additional supply of fiduciary media. Additional loans can be placed only if the interest rate is lowered. Such loans are profitable for the banks because the increase in the supply of fiduciary media calls for no expenditure except for the mechanical costs of banking (i.e., printing the notes and bookkeeping). The banks can, therefore, undercut the interest rates which would otherwise appear on the loan market, in the absence of their intervention. Since competition from them compels other money lenders to lower their interest charges, the market interest rate must therefore decline. But can this reduction be maintained? That is the problem.

3. Inevitable Effects of Credit Expansion on Interest Rates

In conformity with Wicksell's terminology, we shall use “natural interest rate” to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. “Money rate of interest” will be used for that interest rate asked on loans made in money or money substitutes. Through continued expansion of fiduciary media, it is possible for the banks to force the money rate down to the actual cost of the banking operations, practically speaking that is almost to zero. As a result, several authors have concluded that interest could be completely abolished in this way. Whole schools of reformers have wanted to use banking policy to make credit gratuitous and thus to solve the “social question.” No reasoning person today, however, believes that interest can ever be abolished, nor doubts but what, if the “money interest rate” is depressed by the expansion of fiduciary media, it must sooner or later revert once again to the “natural interest rate.” The question is only how this inevitable adjustment takes place. The answer to this will explain at the same time the fluctuations of the business cycle.

The Currency Theory limited the problem too much. It only considered the situation that was of practical significance for the England of its time—that is, when the issue of fiduciary media is increased in one country while remaining unchanged in others. Under these assumptions, the situation is quite clear: General price increases at home; hence an increase in imports, a drop in commodity exports; and with this, as notes can circulate only within the country, an outflow of metallic money. To obtain metallic money for export, holders of notes present them for redemption; the metallic reserves of the banks decline; and consideration for their own solvency then forces them to restrict the credit offered.

That is the instant at which the business upswing, brought about by the availability of easy credit, is demonstrated to be illusory prosperity. An abrupt reaction sets in. The “money rate of interest” shoots up; enterprises from which credit is withdrawn collapse and sweep along with them the banks which are their creditors. A long persisting period of business stagnation now follows. The banks, warned by this experience into observing restraint, not only no longer underbid the “natural interest rate” but exercise extreme caution in granting credit.

4. The Price Premium

In order to complete this interpretation, we must, first of all, consider the price premium. As the banks start to expand the circulation credit, the anticipated upward movement of prices results in the appearance of a positive price premium. Even if the banks do not lower the actual interest rate any more, the gap widens between the “money interest rate” and the “natural interest rate” which would prevail in the absence of their intervention. Since loan money is now cheaper to acquire than circumstances warrant, entrepreneurial ambitions expand.

New businesses are started in the expectation that the necessary capital can be secured by obtaining credit. To be sure, in the face of growing demand, the banks now raise the “money interest rate.” Still they do not discontinue granting further credit. They expand the supply of fiduciary media issued, with the result that the purchasing power of the monetary unit must decline still further. Certainly the actual “money interest rate” increases during the boom, but it continues to lag behind the rate which would conform to the market, i.e., the “natural interest rate” augmented by the positive price premium.

So long as this situation prevails, the upswing continues. Inventories of goods are readily sold. Prices and profits rise. Business enterprises are overwhelmed with orders because everyone anticipates further price increases and workers find employment at increasing wage rates. However, this situation cannot last forever!

5. Malinvestment of Available Capital Goods

The “natural interest rate” is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing “natural interest rate.” Assume, however, that the equilibrium, toward which the market is moving, is disturbed by the interference of the banks. Money may be obtained below the “natural interest rate.” As a result businesses may be started which weren't profitable before, and which become profitable only through the lower than “natural interest rate” which appears with the expansion of circulation credit.

Here again, we see the difference which exists between a drop in purchasing power, caused by the expansion of circulation credit, and a loss of purchasing power, brought about by an increase in the quantity of money. In the latter case [i.e., with an increase in the quantity of money in the narrower sense] the prices first affected are either (1) those of consumers’ goods only or (2) the prices of both consumers’ and producers’ goods. Which it will be depends on whether those first receiving the new quantities of money use this new wealth for consumption or production. However, if the decrease in purchasing power is caused by an increase in bank created fiduciary media, then it is the prices of producers’ goods which are first affected. The prices of consumers’ goods follow only to the extent that wages and profits rise.

Since it always requires some time for the market to reach full “equilibrium,” the “static” or “natural”36 prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new “equilibrium.” At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under “static equilibrium.” With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind.

In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.

6. “Forced Savings”

In recent years, considerable significance has been attributed to the fact that “forced savings,” which may appear as a result of the drop in purchasing power that follows an increase of fiduciary media, leads to an increase in the supply of capital. The subsistence fund is made to go farther, due to the fact that (1) the workers consume less because wage rates tend to lag behind the rise in the prices of commodities, and (2) those who reap the advantage of this reduction in the workers’ incomes save at least a part of their gain. Whether “forced savings” actually appear depends, as noted above, on the circumstances in each case. There is no need to go into this any further.

Nevertheless, establishing the existence of “forced savings” does not mean that bank expansion of circulation credit does not lead to the initiation of more roundabout production than available capabilities would warrant. To prove that, one must be able to show that the banks are only in a position to depress the “money interest rate” and expand the issue of fiduciary media to the extent that the “natural interest rate” declines as a result of “forced savings.” This assumption is simply absurd and there is no point in arguing it further. It is almost inconceivable that anyone should want to maintain it.

What concerns us is the problem brought about by the banks, in reducing the “money rate of interest” below the “natural rate.” For our problem, it is immaterial how much the “natural interest rate” may also decline under certain circumstances and within narrow limits, as a result of this action by the banks. No one doubts that “forced savings” can reduce the “natural interest rate” only fractionally, as compared with the reduction in the “money interest rate” which produces the “forced savings.”37

The resources which are claimed for the newly initiated longer time consuming methods of production are unavailable for those processes where they would otherwise have been put to use. The reduction in the loan rate benefits all producers, so that all producers are now in a position to pay higher wage rates and higher prices for the material factors of production. Their competition drives up wage rates and the prices of the other factors of production. Still, except for the possibilities already discussed, this does not increase the size of the labor force or the supply of available goods of the higher order. The means of subsistence are not sufficient to provide for the workers during the extended period of production. It becomes apparent that the proposal for the new, longer, roundabout production was not adjusted with a view to the actual capital situation. For one thing, the enterprises realize that the resources available to them are not sufficient to continue their operations. They find that “money” is scarce.

That is precisely what has happened. The general increase in prices means that all businesses need more funds than had been anticipated at their “launching.” More resources are required to complete them. However, the increased quantity of fiduciary media loaned out by the banks is already exhausted. The banks can no longer make additional loans at the same interest rates. As a result, they must raise the loan rate once more for two reasons. In the first place, the appearance of the positive price premium forces them to pay higher interest for outside funds which they borrow. Then also, they must discriminate among the many applicants for credit. Not all enterprises can afford this increased interest rate. Those which cannot run into difficulties.

7. A Habit-Forming Policy

Now, in extending circulation credit, the banks do not proceed by pumping a limited dosage of new fiduciary media into circulation and then stop. They expand the fiduciary media continuously for some time, sending, so to speak, after the first offering, a second, third, fourth, and so on. They do not simply undercut the “natural interest rate” once, and then adjust promptly to the new situation. Instead they continue the practice of making loans below the “natural interest rate” for some time. To be sure, the increasing volume of demands on them for credit may cause them to raise the “money rate of interest.” Yet, even if the banks revert to the former “natural rate,” the rate which prevailed before their credit expansion affected the market, they still lag behind the rate which would now exist on the market if they were not continuing to expand credit. This is because a positive price premium must now be included in the new “natural rate.” With the help of this new quantity of fiduciary media, the banks now take care of the businessman's intensified demand for credit. Thus, the crisis does not appear yet. The enterprises using more roundabout methods of production, which have been started, are continued. Because prices rise still further, the earlier calculations of the entrepreneurs are realized. They make profits. In short, the boom continues.

8. The Inevitable Crisis and Cycle

The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.

If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?

They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.

Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.

Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.

The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”

When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.


1. Metallic Standard Fluctuations

From the instant when the banks start expanding the volume of circulation credit, until the moment they stop such behavior, the course of events is substantially similar to that provoked by any increase in the quantity of money. The difference results from the fact that fiduciary media generally come into circulation through the banks, i.e., as loans, while increases in the quantity of money appear as additions to the wealth and income of specific individuals. This has already been mentioned and will not be further considered here. Considerably more significant for us is another distinction between the two.

Such increases and decreases in the quantity of money have no connection with increases or decreases in the demand for money. If the demand for money grows in the wake of a population increase or a progressive reduction of barter and self-sufficiency resulting in increased monetary transactions, there is absolutely no need to increase the quantity of money. It might even decrease. In any event, it would be most extraordinary if changes in the demand for money were balanced by reciprocal changes in its quantity so that both changes were concealed and no change took place in the monetary unit's purchasing power.

Changes in the value of the monetary unit are always taking place in the economy. Periods of declining purchasing power alternate with those of increasing purchasing power. Under a metallic standard, these changes are usually so slow and so insignificant that their effect is not at all violent. Nevertheless, we must recognize that even under a precious metal standard periods of ups and downs would still alternate at irregular intervals. In addition to the standard metallic money, such a standard would recognize only token coins for petty transactions. There would, of course, be no paper money or any other currency (i.e., either notes or bank accounts subject to check which are not fully covered). Yet even then, one would be able to speak of economic “ups,” “downs” and “waves.” However, one would hardly be inclined to refer to such minor alternating “ups” and “downs” as regularly recurring cycles. During these periods when purchasing power moved in one direction, whether up or down, it would probably move so slightly that businessmen would scarcely notice the changes. Only economic historians would become aware of them. Moreover, the fact is that the transition from a period of rising prices to one of falling prices would be so slight that neither panic nor crisis would appear. This would also mean that businessmen and news reports of market activities would be less occupied with the “long waves” of the trade cycle.38

2. Infrequent Recurrences of Paper Money Inflations

The effects of inflations brought about by increases in paper money are quite different. They also produce price increases and hence “good business conditions,” which are further intensified by the apparent encouragement of exports and the hampering of imports. Once the inflation comes to an end, whether by a providential halt to further increases in the quantity of money (as for instance recently in France and Italy) or through complete debasement of the paper money due to inflationary policy carried to its final conclusions (as in Germany in 1923), then the “stabilization crisis”39 appears. The cause and appearance of this crisis correspond precisely to those of the crisis which comes at the close of a period of circulation credit expansion. One must clearly distinguish this crisis [i.e., when increases in the quantity of money are simply halted] from the consequences which must result when the cessation of inflation is followed by deflation.

There is no regularity as to the recurrence of paper money inflations. They generally originate in a certain political attitude, not from events within the economy itself. One can only say, with certainty, that after a country has pursued an inflationist policy to its end or, at least, to substantial lengths, it cannot soon use this means again successfully to serve its financial interests. The people, as a result of their experience, will have become distrustful and would resist any attempt at a renewal of inflation.

Even at the very beginning of a new inflation, people would reject the notes or accept them only at a far greater discount than the actual increased quantity would otherwise warrant. As a rule, such an unusually high discount is characteristic of the final phases of an inflation. Thus an early attempt to return to a policy of paper money inflation must either fail entirely or come very quickly to a catastrophic conclusion. One can assume—and monetary history confirms this, or at least does not contradict it—that a new generation must grow up before consideration can again be given to bolstering the government's finances with the printing press.

Many states have never pursued a policy of paper money inflation. Many have resorted to it only once in their history. Even the states traditionally known for their printing press money have not repeated the experiment often. Austria waited almost a generation after the banknote inflation of the Napoleonic era before embarking on an inflation policy again. Even then, the inflation was in more modest proportions than at the beginning of the nineteenth century. Almost a half century passed between the end of her second and the beginning of her third and most recent period of inflation. It is by no means possible to speak of cyclical reappearances of paper money inflations.

3. The Cycle Process of Credit Expansions

Regularity can be detected only with respect to the phenomena originating out of circulation credit. Crises have reappeared every few years since banks issuing fiduciary media began to play an important role in the economic life of people. Stagnation followed crisis, and following these came the boom again. More than ninety years ago Lord Overstone described the sequence in a remarkably graphic manner:

We find it [the “state of trade”] subject to various conditions which are periodically returning; it revolves apparently in an established cycle. First we find it in a state of quiescence,—next improvement,—growing confidence,—prosperity,—excitement,—overtrading,—convulsion,—pressure,—stagnation,—distress,—ending again in quiescence.40

This description, unrivaled for its brevity and clarity, must be kept in mind to realize how wrong it is to give later economists credit for transforming the problem of the crisis into the problem of general business conditions.

Attempts have been made, with little success, to supplement the observation that business cycles recur by attributing a definite time period to the sequence of events. Theories which sought the source of economic change in recurring cosmic events have, as might be expected, leaned in this direction. A study of economic history fails to support such assumptions. It shows recurring ups and downs in business conditions, but not ups and downs of equal length.

The problem to be solved is the recurrence of fluctuations in business activity. The Circulation Credit Theory shows us, in rough outline, the typical course of a cycle. However, so far as we have as yet analyzed the theory, it still does not explain why the cycle always recurs.

According to the Circulation Credit Theory, it is clear that the direct stimulus which provokes the fluctuations is to be sought in the conduct of the banks. Insofar as they start to reduce the “money rate of interest” below the “natural rate of interest,” they expand circulation credit, and thus divert the course of events away from the path of normal development. They bring about changes in relationships which must necessarily lead to boom and crisis. Thus, the problem consists of asking what leads the banks again and again to renew attempts to expand the volume of circulation credit.

Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and that they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory.41 I could not understand why the banks didn't learn from experience. I thought they would certainly persist in a policy of caution and restraint, if they were not led by outside circumstances to abandon it. Only later did I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks. Only later did I also become convinced that fluctuations in general business conditions were completely dependent on the relationship of the quantity of fiduciary media in circulation to demand.

Each new issue of fiduciary media has the consequences described above. First of all, it depresses the loan rate and then it reduces the monetary unit's purchasing power. Every subsequent issue brings the same result. The establishment of new banks of issue and their step-by-step expansion of circulation credit provides the means for a business boom and, as a result, leads to the crisis with its accompanying decline. We can readily understand that the banks issuing fiduciary media, in order to improve their chances for profit, may be ready to expand the volume of credit granted and the number of notes issued. What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation credit in spite of the spectacular failure of such efforts in the past.

The answer must run as follows: According to the prevailing ideology of businessman and economist-politician, the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal.

4. The Mania for Lower Interest Rates

The naïve inflationist theory of the seventeenth and eighteenth centuries could not stand up in the long run against the criticism of economics. In the nineteenth century, that doctrine was held only by obscure authors who had no connection with scientific inquiry or practical economic policy. For purely political reasons, the school of empirical and historical “Realism” did not pay attention to problems of economic theory. It was due only to this neglect of theory that the naïve theory of inflation was once more able to gain prestige temporarily during the World War, especially in Germany.

The doctrine of inflationism by way of fiduciary media was more durable. Adam Smith had battered it severely, as had others even before him, especially the American William Douglass.42 Many, notably in the Currency School, had followed. But then came a reversal. The Banking School confused the situation. Its founders failed to see the error in their doctrine. They failed to see that the expansion of circulation credit lowered the interest rate. They even argued that it was impossible to expand credit beyond the “needs of business.” So there are seeds in the Banking Theory which need only to be developed to reach the conclusion that the interest rate can be reduced by the conduct of the banks. At the very least, it must be admitted that those who dealt with those problems did not sufficiently understand the reasons for opposing credit expansion to be able to overcome the public clamor for the banks to provide “cheap money.”

In discussions of the rate of interest, the economic press adopted the questionable jargon of the business world, speaking of a “scarcity” or an “abundance” of money and calling the short term loan market the “money market.” Banks issuing fiduciary media, warned by experience to be cautious, practiced discretion and hesitated to indulge the universal desire of the press, political parties, parliaments, governments, entrepreneurs, landowners and workers for cheaper credit. Their reluctance to expand credit was falsely attributed to reprehensible motives. Even newspapers, that knew better, and politicians, who should have known better, never tired of asserting that the banks of issue could certainly discount larger sums more cheaply if they were not trying to hold the interest rate as high as possible out of concern for their own profitability and the interests of their controlling capitalists.

Almost without exception, the great European banks of issue on the continent were established with the expectation that the loan rate could be reduced by issuing fiduciary media. Under the influence of the Currency School doctrine, at first in England and then in other countries where old laws did not restrict the issue of notes, arrangements were made to limit the expansion of circulation credit, at least of that part granted through the issue of uncovered banknotes. Still, the Currency Theory lost out as a result of criticism by Tooke (1774–1858) and his followers. Although it was considered risky to abolish the laws which restricted the issue of notes, no harm was seen in circumventing them. Actually, the letter of the banking laws provided for a concentration of the nation's supply of precious metals in the vaults of banks of issue. This permitted an increase in the issue of fiduciary media and played an important role in the expansion of the gold exchange standard.

Before the war [1914], there was no hesitation in Germany in openly advocating withdrawal of gold from trade so that the Reichsbank might issue sixty marks in notes for every twenty marks in gold added to its stock. Propaganda was also made for expanding the use of payments by check with the explanation that this was a means to lower the interest rate substantially.43 The situation was similar elsewhere, although perhaps more cautiously expressed.

Every single fluctuation in general business conditions—the upswing to the peak of the wave and the decline into the trough which follows—is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit through an increase in the supply of fiduciary media (i.e., banknotes and checking accounts not fully backed by money). The fact that these efforts are resumed again and again in spite of their widely deplored consequences, causing one business cycle after another, can be attributed to the predominance of an ideology—an ideology which regards rising commodity prices and especially a low rate of interest as goals of economic policy. The theory is that even this second goal may be attained by the expansion of fiduciary media. Both crisis and depression are lamented. Yet, because the causal connection between the behavior of the banks of issue and the evils complained about is not correctly interpreted, a policy with respect to interest is advocated which, in the last analysis, must necessarily always lead to crisis and depression.

5. Free Banking

Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic “equilibrium.” This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis.

The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy.

Even if governments had never concerned themselves with the issue of fiduciary media, there would still be banks of issue and fiduciary media in the form of notes as well as checking accounts. There would then be no legal limitation on the issue of fiduciary media. Free banking would prevail. However, banks would have to be especially cautious because of the sensitivity to loss of reputation of their fiduciary media, which no one would be forced to accept. In the course of time, the inhabitants of capitalistic countries would learn to differentiate between good and bad banks. Those living in “undeveloped” countries would distrust all banks. No government would exert pressure on the banks to discount on easier terms than the banks themselves could justify. However, the managers of solvent and highly respected banks, the only banks whose fiduciary media would enjoy the general confidence essential for money-substitute quality, would have learned from past experiences. Even if they scarcely detected the deeper correlations, they would nevertheless know how far they might go without precipitating the danger of a breakdown.

The cautious policy of restraint on the part of respected and well-established banks would compel the more irresponsible managers of other banks to follow suit, however much they might want to discount more generously. For the expansion of circulation credit can never be the act of one individual bank alone, nor even of a group of individual banks. It always requires that the fiduciary media be generally accepted as a money substitute. If several banks of issue, each enjoying equal rights, existed side by side, and if some of them sought to expand the volume of circulation credit while the others did not alter their conduct, then at every bank clearing, demand balances would regularly appear in favor of the conservative enterprises. As a result of the presentation of notes for redemption and withdrawal of their cash balances, the expanding banks would very quickly be compelled once more to limit the scale of their emissions.

In the course of the development of a banking system with fiduciary media, crises could not have been avoided. However, as soon as bankers recognized the dangers of expanding circulation credit, they would have done their utmost, in their own interests, to avoid the crisis. They would then have taken the only course leading to this goal: extreme restraint in the issue of fiduciary media.

6. Government Intervention in Banking

The fact that the development of fiduciary media banking took a different turn may be attributed entirely to the circumstance that the issue of banknotes (which for a long time were the only form of fiduciary media and are today [1928] still the more important, even in the United States and England) became a public concern. The private bankers and joint-stock banks were supplanted by the politically privileged banks of issue because the governments favored the expansion of circulation credit for reasons of fiscal and credit policy. The privileged institutions could proceed unhesitatingly in the granting of credit, not only because they usually held a monopoly in the issue of notes, but also because they could rely on the government's help in an emergency. The private banker would go bankrupt, if he ventured too far in the issue of credit. The privileged bank received permission to suspend payments and its notes were made legal tender at face value.

If the knowledge derived from the Currency Theory had led to the conclusion that fiduciary media should be deprived of all special privileges and placed, like other claims, under general law in every respect and without exception, this would probably have contributed more toward eliminating the threat of crises than was actually accomplished by establishing rigid proportions for the issue of fiduciary media in the form of notes and restricting the freedom of banks to issue fiduciary media in the form of checking accounts. The principle of free banking was limited to the field of checking accounts. In fact, it could not function here to bring about restraint on the part of banks and bankers. Public opinion decreed that government should be guided by a different policy—a policy of coming to the assistance of the central banks of issue in times of crises. To permit the Bank of England to lend a helping hand to banks which had gotten into trouble by expanding circulation credit, the Peel Act was suspended in 1847, 1857 and 1866. Such assistance, in one form or another, has been offered time and again everywhere.

In the United States, national banking legislation made it technically difficult, if not entirely impossible, to grant such aid. The system was considered especially unsatisfactory, precisely because of the legal obstacles it placed in the path of helping grantors of credit who became insolvent and of supporting the value of circulation credit they had granted. Among the reasons leading to the significant revision of the American banking system [i.e., the Federal Reserve Act of 1913], the most important was the belief that provisions must be made for times of crises. In other words, just as the emergency institution of Clearing House Certificates was able to save expanding banks, so should technical expedients be used to prevent the breakdown of the banks and bankers whose conduct had led to the crisis. It was usually considered especially important to shield the banks which expanded circulation credit from the consequences of their conduct. One of the chief tasks of the central banks of issue was to jump into this breach. It was also considered the duty of those other banks who, thanks to foresight, had succeeded in preserving their solvency, even in the general crisis, to help fellow banks in difficulty.

7. Intervention No Remedy

It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course. Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still the total loss brought about by the “boom” (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. As a result, these factors of production are now lacking for more urgent uses. If intervention prevents the transfer of goods from the hands of imprudent entrepreneurs to those who would now take over because they have evidenced better foresight, this imbalance becomes neither less significant nor less perceptible.

In any event, the practice of intervening for the benefit of banks, rendered insolvent by the crisis, and of the customers of these banks, has resulted in suspending the market forces which could serve to prevent a return of the expansion, in the form of a new boom, and the crisis which inevitably follows. If the banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit? If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs—not only banks but also other businessmen—would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit.

To the businessman, it appears most natural and understandable that the banks should satisfy his demand for credit by the creation of fiduciary media. The banks, he believes, should have the task and the duty to “stand by” business and trade. There is no dispute but that the expansion of circulation credit furthers the accumulation of capital within the narrow limits of the “forced savings” it brings about and to that extent permits an increase in productivity. Still it can be argued that, given the situation, each step in this direction steers business activity, in the manner described above, on a “wrong” course. The discrepancy between what the entrepreneurs do and what the unhampered market would have prescribed becomes evident in the crisis. The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups—political economists, politicians, statesmen, the press and the business world—not only sanctions, but also demands, the expansion of circulation credit.


1. The Inadequacy of the Currency School

Every advance toward explaining the problem of business fluctuations to date is due to the Currency School. We are also indebted to this School alone for the ideas responsible for policies aimed at eliminating business fluctuations. The fatal error of the Currency School consisted in the fact that it failed to recognize the similarity between banknotes and bank demand deposits as money substitutes and, thus, as money certificates and fiduciary media. In their eyes, only the banknote was a money substitute. In their view, therefore, the circulation of pure metallic money could only be adulterated by the introduction of a banknote not covered by money.

Consequently, they thought that the only thing that needed to be done to prevent the periodic return of crises was to set a rigid limit for the issue of banknotes not backed by metal. The issue of fiduciary media in the form of demand deposits not covered by metal was left free.44 Since nothing stood in the way of granting circulation credit through bank deposits, the policy of expanding circulation credit could be continued even in England. When technical difficulties limited further bank loans and precipitated a crisis, it became customary to come to the assistance of the banks and their customers with special issues of notes. The practice of restricting the notes in circulation not covered by metal, by limiting the ratio of such notes to metal, systematized this procedure. Banks could expand the volume of credit with ease if they could count on the support of the bank of issue in an emergency.

If all further expansion of fiduciary media had been forbidden in any form, that is, if the banks had been obliged to hold full reserves for both the additional notes issued and increases in customers’ demand deposits subject to check or similar claim—or at least had not been permitted to increase the quantity of fiduciary media beyond a strictly limited ratio—prices would have declined sharply, especially at times when the increased demand for money surpassed the increase in its quantity. The economy would then not only have lacked the drive contributed by any “forced savings,” it would also have temporarily suffered from the consequences of a rise in the monetary unit's purchasing power [i.e., falling prices]. Capital accumulation would then have been slowed down, although certainly not stopped. In any case, the economy surely would not then have experienced periods of stormy upswings followed by dramatic reversals of the upswings into crises and declines.

There is little sense in discussing whether it would have been better to restrict, in this way, the issue of fiduciary media by the banks than it was to pursue the policy actually followed. The alternatives are not merely restriction or freedom in the issue of fiduciary media. The alternatives are, or at least were, privilege in the granting of fiduciary media or true free banking.

The possibility of free banking has scarcely even been suggested. Intervention cast its first shadow over the capitalistic system when banking policy came to the forefront of economic and political discussion. To be sure, some authors, who defended free banking, appeared on the scene. However, their voices were overpowered. The desired goal was to protect the noteholders against the banks. It was forgotten that those hurt by the dangerous suspension of payments by the banks of issue are always the very ones the law was intended to help. No matter how severe the consequences one may anticipate from a breakdown of the banks under a system of absolutely free banking, one would have to admit that they could never even remotely approach the severity of those brought about by the war and postwar banking policies of the three European empires.45

2. “Booms” Favored

In the last two generations, hardly anyone, who has given this matter some thought, can fail to know that a crisis follows a boom. Nevertheless, it would have been impossible for even the sharpest and cleverest banker to suppress in time the expansion of circulation credit. Public opinion stood in the way. The fact that business conditions fluctuated violently was generally assumed to be inherent in the capitalistic system. Under the influence of the Banking Theory, it was thought that the banks merely went along with the upswing and that their conduct had nothing to do with bringing it about or advancing it. If, after a long period of stagnation, the banks again began to respond to the general demand for easier credit, public opinion was always delighted by the signs of the start of a boom.

In view of the prevailing ideology, it would have been completely unthinkable for the banks to apply the brakes at the start of such a boom. If business conditions continued to improve, then, in conformity with the principles of Lord Overstone, prophecies of a reaction certainly increased in number. However, even those who gave this warning usually did not call for a rigorous halt to all further expansion of circulation credit. They asked only for moderation and for restricting newly granted credits to “non-speculative” businesses.

Then finally, if the banks changed their policy and the crisis came, it was always easy to find culprits. But there was no desire to locate the real offender—the false theoretical doctrine. So no changes were made in traditional procedures. Economic waves continued to follow one another.

The managers of the banks of issue have carried out their policy without reflecting very much on its basis. If the expansion of circulation credit began to alarm them, they proceeded, not always very skillfully, to raise the discount rate. Thus, they exposed themselves to public censure for having initiated the crisis by their behavior. It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.


1. Pre-World War I Policy

The cyclical policy recommended today, in most of the literature dealing with the problem of business fluctuations and toward which considerable strides have already been made in the United States, rests entirely on the reasoning of the Circulation Credit Theory.46 The aim of much of this literature is to make this theory useful in practice by studying business conditions with precise statistical methods.

There is no need to explain further that there is only one business cycle theory—the Circulation Credit Theory. All other attempts to cope with the problem have failed to withstand criticism. Every crisis policy and every cyclical policy has been derived from this theory. Its ideas have formed the basis of those cyclical and crisis policies pursued in the decades preceding the war. Thus, the Banking Theory, then recognized in literature as the only correct explanation, as well as all those interpretations which related the problem to the theory of direct exchange, were already disregarded. It may have still been popular to speak of the elasticity of notes in circulation as depending on the discounting of commodity bills of exchange. However, in the world of the bank managers, who made cyclical policy, other views prevailed.

To this extent, therefore, one cannot say that the theory behind today's cyclical policy is new. The Circulation Credit Theory has, to be sure, come a long way from the old Currency Theory. The studies which Walras, Wicksell and I have devoted to the problem have conceived of it as a more general phenomenon. These studies have related it to the whole economic process. They have sought to deal with it especially as a problem of interest rate formulation and of “equilibrium” on the loan market. To recognize the extent of the progress made, compare, for instance, the famous controversy over free credit between Bastiat and Proudhon.47 Or compare the usual criticism of the Quantity Theory in prewar German literature with recent discussions on the subject. However, no matter how significant this progress may be considered for the development of our understanding, we should not forget that the Currency Theory had already offered policy making every assistance in this regard that a theory can.

It is certainly not to be disputed that substantial progress was made when the problem was considered, not only from the point of view of fiduciary media, but from that of the entire problem of the purchasing power of money. The Currency School paid attention to price changes only insofar as they were produced by an increase or decrease of circulation credit—but they considered only the circulation credit granted by the issue of notes. Thus, the Currency School was a long way from striving for stabilization of the purchasing power of the monetary unit.

2. Post-World War I Policies

Today these two problems, the issuance of fiduciary media and the purchasing power of the monetary unit, are seen as being closely linked to the Circulation Credit Theory. One of the tendencies of modern cyclical policy is that these two problems are treated as one. Thus, one aim of cyclical policy is no more nor less than the stabilization of the purchasing power of money. For a discussion of this see Part I of this study.

Like the Currency School, the other aim is not to stabilize purchasing power but only to avoid the crisis. However, a still further goal is contemplated—similar to that sought by the Peel Act and by prewar cyclical policy. It is proposed to counteract a boom, whether caused by an expansion of fiduciary media or by a monetary inflation (for example, an increase in the production of gold). Then, again, depression is to be avoided when there is restriction irrespective of whether it starts with a contraction in the quantity of money or of fiduciary media. The aim is not to keep prices stable, but to prevent the free market interest rate from being reduced temporarily by the banks of issue or by monetary inflation.

In order to explain the essence of this new policy, we shall now explore two specific cases in more detail:

1. The production of gold increases and prices rise. A price premium appears in the interest rate that would limit the demand for loans to the supply of lendable funds available. The banks, however, have no reason to raise their lending rate. As a matter of fact, they become more willing to discount at a lower rate as the relationship between their obligations and their stock of gold has been improved. It has certainly not deteriorated. The actual loan rate they are asking lags behind the interest rate that would prevail on a free market, thus providing the initiative for a boom. In this instance, prewar crisis policy would not have intervened since it considered only the ratio of the bank's cover which had not deteriorated. As prices and wages rise [resulting in an increased demand for business loans], modern theory maintains that the interest rates should rise and circulation credit be restricted.

2. The inducement to the boom has been given by the banks in response, let us say, to the general pressure to make credit cheaper in order to combat depression, without any change in the quantity of money in the narrower sense. Since the cover ratio deteriorates as a result, even the older crisis policy would have called for increasing the interest rate as a brake.

Only in the first of these two instances does a fundamental difference exist between old and new policies.

3. Empirical Studies

Many now engaged in cyclical research maintain that the special superiority of current crisis policy in America rests on the use of more precise statistical methods than those previously available. Presumably, means for eliminating seasonal fluctuations and the secular general trend have been developed from statistical series and curves. Obviously, it is only with such manipulations that the findings of a market study may become a study of the business cycle. However, even if one should agree with the American investigators in their evaluation of the success of this effort, the question remains as to the usefulness of index numbers. Nothing more can be added to what has been said above on the subject, in Part I of this study.

The development of the Three Market Barometer48 is considered the most important accomplishment of the Harvard investigations. Since it is not possible to determine Wicksell's natural rate of interest or the “ideal” price premium, we are advised to compare the change in the interest rate with the movement of prices and other data indicative of business conditions, such as production figures, the number of unemployed, etc. This has been done for decades. One need only glance at reports in the daily papers, economic weeklies, monthlies and annuals of the last two generations to discover that the many claims, made so proudly today, of being the first to recognize the significance of such data for understanding the course of business conditions, are unwarranted. The Harvard institute, however, has performed a service in that it has sought to establish an empirical regularity in the timing of the movements in the three curves.

There is no need to share the exuberant expectations for the practical usefulness of the Harvard barometer which has prevailed in the American business world for some time. It can readily be admitted that this barometer has scarcely contributed anything toward increasing and deepening our knowledge of cyclical movements. Nevertheless, the significance of the Harvard barometer for the investigation of business conditions may still be highly valued, for it does provide statistical substantiation of the Circulation Credit Theory. Twenty years ago, it would not have been thought possible to arrange and manipulate statistical material so as to make it useful for the study of business conditions. Here real success has crowned the ingenious work done by economists and statisticians together.

Upon examining the curves developed by institutes using the Harvard method, it becomes apparent that the movement of the money market curve (C Curve) in relation to the stock market curve (A Curve) and the commodity market curve (B Curve) corresponds exactly to what the Circulation Credit Theory asserts. The fact that the movements of A Curve generally anticipate those of B Curve is explained by the greater sensitivity of stock, as opposed to commodity, speculation. The stock market reacts more promptly than does the commodity market. It sees more and it sees farther. It is quicker to draw coming events (in this case, the changes in the interest rate) into the sphere of its conjectures.

4. Arbitrary Political Decisions

However, the crucial question still remains: What does the Three Market Barometer offer the man who is actually making bank policy? Are modern methods of studying business conditions better suited than the former, to be sure less thorough, ones for laying the groundwork for decisions on a discount policy aimed at reducing as much as possible the ups and downs of business? Even prewar [World War I] banking policy had this for its goal. There is no doubt but that government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses, were frankly and sincerely interested in attaining this goal. Their efforts in this direction—only when the boom was already in full swing to be sure—were supported at least by a segment of public opinion and of the press. They knew well enough what was needed to accomplish the desired effect. They knew that nothing but a timely and sufficiently far-reaching increase in the loan rate could counteract what was usually referred to as “excessive speculation.”

They failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. However, this fact did not prevent them, once the cyclical upswing became obvious, from thinking about its unavoidable outcome. They did not know that the upswing had been generated by the conduct of the banks. If they had, they might well have seen it only as a blessing of banking policy, for to them the most important task of economic policy was to overcome the depression, at least so long as the depression lasted. Still they knew that a progressing upswing must lead to crisis and then to stagnation.

As a result, the trade boom evoked misgivings at once. The immediate problem became simply how to counteract the onward course of the “unhealthy” development. There was no question of “whether,” but only of “how.” Since the method—increasing the interest rate—was already settled, the question of “how” was only a matter of timing and degree: When and how much should the interest rate be raised?

The critical point was that this question could not be answered precisely, on the basis of undisputed data. As a result, the decision must always be left to discretionary judgment. Now, the more firmly convinced those responsible were that their interference, by raising the interest rate, would put an end to the prosperity of the boom, the more cautiously they must act. Might not those voices be correct which maintained that the upswing was not “artificially” produced, that there wasn't any “overspeculation” at all, that the boom was only the natural outgrowth of technical progress, the development of means of communication, the discovery of new supplies of raw materials, the opening up of new markets? Should this delightful and happy state of affairs be rudely interrupted? Should the government act in such a way that the economic improvement, for which it took credit, gives way to crisis?

The hesitation of officials to intervene is sufficient to explain the situation. To be sure, they had the best of intentions for stopping in time. Even so, the steps they took were usually “too little and too late.” There was always a time lag before the interest rate reached the point at which prices must start down again. In the interim, capital had become frozen in investments for which it would not have been used if the interest rate on money had not been held below its “natural rate.”

This drawback to cyclical policy is not changed in any respect if it is carried out in accordance with the business barometer. No one who has carefully studied the conclusions, drawn from observations of business conditions made by institutions working with modern methods, will dare to contend that these results may be used to establish, incontrovertibly, when and how much to raise the interest rate in order to end the boom in time before it has led to capital malinvestment. The accomplishment of economic journalism in reporting regularly on business conditions during the last two generations should not be underrated. Nor should the contribution of contemporary business cycle research institutes, working with substantial means, be overrated. Despite all the improvements which the preparation of statistics and graphic interpretations have undergone, their use in the determination of interest rate policy still leaves a wide margin for judgment.

5. Sound Theory Essential

Moreover, it should not be forgotten that it is impossible to answer in a straightforward manner not only how seasonal variations and growth factors are to be eliminated, but also how to decide unequivocably from what data and by what method the curves of each of the Three Markets should be constructed. Arguments which cannot be easily refuted may be raised on every point with respect to the business barometer. Also, no matter how much the business barometer may help us to survey the many heterogeneous operations of the market and of production, they certainly do not offer a solid basis for weighing contingencies. Business barometers are not even in a position to furnish clear and certain answers to the questions concerning cyclical policy which are crucial for their operation. Thus, the great expectations generally associated with recent cyclical policy today are not justified.

For the future of cyclical policy more profound theoretical knowledge concerning the nature of changes in business conditions would inevitably be of incomparably greater value than any conceivable manipulation of statistical methods. Some business cycle research institutes are imbued with the erroneous idea that they are conducting impartial factual research, free of any prejudice due to theoretical considerations. In fact, all their work rests on the groundwork of the Circulation Credit Theory. In spite of the reluctance which exists today against logical reasoning in economics and against thinking problems and theories through to their ultimate conclusions, a great deal would be gained if it were decided to base cyclical policy deliberately on this theory. Then, one would know that every expansion of circulation credit must be counteracted in order to even out the waves of the business cycle. Then, a force operating on one side to reduce the purchasing power of money would be offset from the other side. The difficulties, due to the impossibility of finding any method for measuring changes in purchasing power, cannot be overcome. It is impossible to realize the ideal of either a monetary unit of unchanging value or economic stability. However, once it is resolved to forgo the artificial stimulation of business activity by means of banking policy, fluctuations in business conditions will surely be substantially reduced. To be sure this will mean giving up many a well-loved slogan, for example, “easy money” to encourage credit transactions. However, a still greater ideological sacrifice than that is called for. The desire to reduce the interest rate in any way must also be abandoned.

It has already been pointed out that events would have turned out very differently if there had been no deviation from the principle of complete freedom in banking and if the issue of fiduciary media had been in no way exempted from the rules of commercial law. It may be that a final solution of the problem can be arrived at only through the establishment of completely free banking. However, the credit structure which has been developed by the continued effort of many generations cannot be transformed with one blow. Future generations, who will have recognized the basic absurdity of all interventionist attempts, will have to deal with this question also. However, the time is not yet ripe—not now nor in the immediate future.


1. International Competition or Cooperation

There are many indications that public opinion has recognized the significance of the role banks play in initiating the cycle by their expansion of circulation credit. If this view should actually prevail, then the previous popularity of efforts aimed at artificially reducing the interest rate on loans would disappear. Banks that wanted to expand their issue of fiduciary media would no longer be able to count on public approval or government support. They would become more careful and more temperate. That would smooth out the waves of the cycle and reduce the severity of the sudden shift from rise to fall.

However, there are some indications which seem to contradict this view of public opinion. Most important among these are the attempts or, more precisely, the reasoning which underlies the attempts to bring about international cooperation among the banks of issue.

In speculative periods of the past, the very fact that the banks of the various countries did not work together systematically, and according to agreement, constituted a most effective brake. With closely-knit international economic relations, the expansion of circulation credit could only become universal if it were an international phenomenon. Accordingly, lacking any international agreement, individual banks, fearing a large outflow of capital, took care in setting their interest rates not to lag far below the rates of the banks of other countries. Thus, in response to interest rate arbitrage and any deterioration in the balance of trade, brought about by higher prices, an exodus of loan money to other countries would, for one thing, have impaired the ratio of the bank's cover, as a result of foreign claims on their gold and foreign exchange which such conditions impose on the bank of issue. The bank, obliged to consider its solvency, would then be forced to restrict credit. In addition, this impairment of the ever-shifting balance of payments would create a shortage of funds on the money market which the banks would be powerless to combat. The closer the economic connections among peoples become, the less possible it is to have a national boom. The business climate becomes an international phenomenon.

However, in many countries, especially in the German Reich, the view has frequently been expressed by friends of “cheap money” that it is only the gold standard that forces the bank of issue to consider interest rates abroad in determining its own interest policy. According to this view, if the bank were free of this shackle, it could then better satisfy the demands of the domestic money market, to the advantage of the national economy. With this view in mind, there were in Germany advocates of bimetallism, as well as of a gold premium policy.49 In Austria, there was resistance to formalizing legally the de facto practice of redeeming its notes.

It is easy to see the fallacy in this doctrine that only the tie of the monetary unit to gold keeps the banks from reducing interest rates at will. Even if all ties with the gold standard were broken, this would not have given the banks the power to lower the interest rate, below the height of the “natural” interest rate, with impunity. To be sure, the paper standard would have permitted them to continue the expansion of circulation credit without hesitation, because a bank of issue, relieved of the obligation of redeeming its notes, need have no fear with respect to its solvency. Still, the increase in notes would have led first to price increases and consequently to a deterioration in the rate of exchange. Second, the crisis would have come—later, to be sure, but all the more severely.

If the banks of issue were to consider seriously making agreements with respect to discount policy, this would eliminate one effective check. By acting in unison, the banks could extend more circulation credit than they do now, without any fear that the consequences would lead to a situation which produces an external drain of funds from the money market. To be sure, if this concern with the situation abroad is eliminated, the banks are still not always in a position to reduce the money rate of interest below its “natural” rate in the long run. However, the difference between the two interest rates can be maintained longer, so that the inevitable result—malinvestment of capital—appears on a larger scale. This must then intensify the unavoidable crisis and deepen the depression.

So far, it is true, the banks of issue have made no significant agreements on cyclical policy. Nevertheless, efforts aimed at such agreements are certainly being proposed on every side.

2. “Boom” Promotional Problems

Another dangerous sign is that the slogan concerning the need to “control the money market,” through the banks of issue, still retains its prestige.

Given the situation, especially as it has developed in Europe, only the central banks are entitled to issue notes. Under that system, attempts to expand circulation credit universally can only originate with the central bank of issue. Every venture on the part of private banks, against the wish or the plan of the central bank, is doomed from the very beginning. Even banking techniques, learned from the Anglo-Saxons, are of no service to private banks, since the opportunity for granting credit, by opening bank deposits, is insignificant in countries where the use of checks (except for central bank clearings and the circulation of postal checks) is confined to a narrow circle in the business world. However, if the central bank of issue embarks upon a policy of credit expansion and thus begins to force down the rate of interest, it may be advantageous for the largest private banks to follow suit and expand the volume of circulation credit they grant too. Such a procedure has still a further advantage for them. It involves them in no risk. If confidence is shaken during the crisis, they can survive the critical stage with the aid of the bank of issue.

However, the bank of issue's credit expansion policy certainly offers a large number of banks a profitable field for speculation—arbitrage in the loan rates of interest. They seek to profit from the shifting ratio between domestic and foreign interest rates by investing domestically obtained funds in short term funds abroad. In this process, they are acting in opposition to the discount policy of the bank of issue and hurting the alleged interests of those groups which hope to benefit from the artificial reduction of the interest rate and from the boom it produces. The ideology, which sees salvation in every effort to lower the interest rate and regards expansion of circulation credit as the best method of attaining this goal, is consistent with the policy of branding the actions of the interest rate arbitrageur as scandalous and disgraceful, even as a betrayal of the interests of his own people to the advantage of foreigners. The policy of granting the banks of issue every possible assistance in the fight against these speculators is also consistent with this ideology. Both government and bank of issue seek to intimidate the malefactors with threats, to dissuade them from their plan. In the liberal50 countries of western Europe, at least in the past, little could be accomplished by such methods. In the interventionist countries of middle and eastern Europe, attempts of this kind have met with greater success.

It is easy to see what lies behind this effort of the bank of issue to “control” the money market. The bank wants to prevent its credit expansion policy, aimed at reducing the interest rate, from being impeded by consideration of relatively restrictive policies followed abroad. It seeks to promote a domestic boom without interference from international reactions.

3. Drive for Tighter Controls

According to the prevailing ideology, however, there are still other occasions when the banks of issue should have stronger control over the money market. If the interest rate arbitrage, resulting from the expansion of circulation credit, has led, for the time being, only to a withdrawal of funds from the reserves of the issuing bank, and that bank, disconcerted by the deterioration of the security behind its notes, has proceeded to raise its discount rate, there may still be, under certain conditions, no cause for the loan rate to rise on the open money market. As yet no funds have been withdrawn from the domestic market. The gold exports came from the bank's reserves, and the increase in the discount rate has not led to a reduction in the credits granted by the bank. It takes time for loan funds to become scarce as a result of the fact that some commercial paper, which would otherwise have been offered to the bank for discount, is disposed of on the open market. The issuing bank, however, does not want to wait so long for its maneuver to be effective. Alarmed at the state of its gold and foreign exchange assets, it wants prompt relief. To accomplish this, it must try to make money scarce on the market. It generally tries to bring this about by appearing itself as a borrower on the market.

Another case, when control of the money market is contested, concerns the utilization of funds made available to the market by the generous discount policy. The dominant ideology favors “cheap money.” It also favors high commodity prices, but not always high stock market prices. The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the “producer” is dissatisfied. He envies the “speculator” his “easy profit.” Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.

Therefore, the aim is to withdraw money from stock exchange loans in order to inject it into the “economy.” Trying to do this simply by raising the interest rate offers no special attraction. Such a rise in the interest rate is certainly unavoidable in the end. It is only a question of whether it comes sooner or later. Whenever the interest rate rises sufficiently, it brings an end to the business boom. Therefore, other measures are tried to transfer funds from the stock market into production, without changing the cheap rate for loans. The bank of issue exerts pressure on borrowers to influence the use made of the sums loaned out. Or else it proceeds directly to set different terms for credit depending on its use.

Thus we can see what it means if the central bank of issue aims at domination of the money market. Either the expansion of circulation credit is freed from the limitations which would eventually restrict it or the boom is shifted by certain measures along a course different from the one it would otherwise have followed. Thus, the pressure for “control of the money market” specifically envisions the encouragement of the boom—the boom which must end in a crisis. If a cyclical policy is to be followed to eliminate crises, this desire, the desire to control and dominate the money market, must be abandoned.

If it were seriously desired to counteract price increases resulting from an increase in the quantity of money—due to an increase in the mining of gold, for example—by restricting circulation credit, the central banks of issue would borrow more on the market. Paying off these obligations later could hardly be described as “controlling the money market.” For the bank of issue, the restriction of circulation credit means the renunciation of profits. It may even mean losses.

Moreover, such a policy can be successful only if there is agreement among the banks of issue. If restriction were practiced by the central bank of one country only, it would result in relatively high costs of borrowing money within that country. The chief consequence of this would then be that gold would flow in from abroad. Insofar as this is the goal sought by the cooperation of the banks, it certainly cannot be considered a dangerous step in the attempt toward a policy of evening out the waves of the business cycle.


1. Contributions of Business Cycle Research

The popularity enjoyed by contemporary business cycle research, the development of which is due above all to American economic researchers, derives from exaggerated expectations as to its usefulness in practice. With its help, it had been hoped to mechanize banking policy and business activity. It had been hoped that a glance at the business barometer would tell businessmen and those who determine banking policy how to act.

At present, this is certainly out of the question. It has already been emphasized often enough that the results of business cycle studies have only described past events and that they may be used for predicting future developments only on the basis of extremely inadequate principles. However—and this is not sufficiently noted—these principles apply solely on the assumption that the ideology calling for expansion of circulation credit has not lost its standing in the field of economic and banking policy. Once a serious start is made at directing cyclical policy toward the elimination of crises, the power of this ideology is already dissipated.

Nevertheless, one broad field remains for the employment of the results of contemporary business cycle studies. They should indicate to the makers of banking policy when the interest rate must be raised to avoid instigating credit expansion. If the study of business conditions were clear on this point and gave answers admitting of only one interpretation, so that there could be only one opinion, not only as to whether but also as to when and how much to increase the discount rate, then the advantage of such studies could not be rated highly enough. However, this is not the case. Everything that the observation of business conditions contributes in the form of manipulated data and material can be interpreted in various ways.

Even before the development of business barometers, it was already known that increases in stock market quotations and commodity prices, a rise in profits on raw materials, a drop in unemployment, an increase in business orders, the selling off of inventories, and so on, signified a boom. The question is, when should, or when must, the brakes be applied. However, no business cycle institute answers this question straightforwardly and without equivocation. What should be done will always depend on an examination of the driving forces which shape business conditions and on the objectives set for cyclical policy. Whether the right moment for action is seized can never be decided except on the basis of a careful observation of all market phenomena. Moreover, it has never been possible to answer this question in any other way. The fact that we now know how to classify and describe the various market data more clearly than before does not make the task essentially any easier.

A glance at the continuous reports on the economy and the stock market in the large daily newspapers and in the economic weeklies, which appeared from 1840 to 1910, shows that attempts have been made for decades to draw conclusions from events of the most recent past, on the basis of empirical rules, as to the shape of the immediate future. If we compare the statistical groundwork used in these attempts with those now at our disposal, then it is obvious that we have recourse to more data today. We also understand better how to organize this material, how to arrange it clearly and interpret it for graphic presentation. However, we can by no means claim, with the modern methods of studying business conditions, to have embarked on some new principle.

2. Difficulties of Precise Prediction

No businessman may safely neglect any available source of information. Thus no businessman can refuse to pay close attention to newspaper reports. Still diligent newspaper reading is no guarantee of business success. If success were that easy, what wealth would the journalists have already amassed! In the business world, success depends on comprehending the situation sooner than others do—and acting accordingly. What is recognized as “fact” must first be evaluated correctly to make it useful for an undertaking. Precisely this is the problem of putting theory into practice.

A prediction, which makes judgments which are qualitative only and not quantitative, is practically useless even if it is eventually proved right by the later course of events. There is also the crucial question of timing. Decades ago, Herbert Spencer recognized, with brilliant perception, that militarism, imperialism, socialism and interventionism must lead to great wars, severe wars. However, anyone who had started about 1890, to speculate on the strength of that insight on a depreciation of the bonds of the Three Empires51 would have sustained heavy losses. Large historical perspectives furnish no basis for stock market speculations which must be reviewed daily, weekly, or monthly at least.

It is well known that every boom must one day come to an end. The businessman's situation, however, depends on knowing exactly when and where the break will first appear. No economic barometer can answer these questions. An economic barometer only furnishes data from which conclusions may be drawn. Since it is still possible for the central bank of issue to delay the start of the catastrophe with its discount policy, the situation depends chiefly on making judgments as to the conduct of these authorities. Obviously, all available data fail at this point.

But once public opinion is completely dominated by the view that the crisis is imminent and businessmen act on this basis, then it is already too late to derive business profit from this knowledge. Or even merely to avoid losses. For then the panic breaks out. The crisis has come.


1. Revised Currency School Theory

Without doubt, expanding the sphere of scientific investigation from the narrow problem of the crisis into the broader problem of the cycle represents progress.52 However, it was certainly not equally advantageous for political policies. Their scope was broadened. They began to aspire to more than was feasible.

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

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

The banks would be obliged at all times to maintain metallic backing for all notes—except for the sum of those outstanding which are not now covered by metal—equal to the total sum of the notes issued and bank deposits opened. That would mean a complete reorganization of central bank legislation. The banks of issue would have to return to the principles of Peel's Bank Act, but with the provisions expanded to cover also bank balances subject to check. The same stipulations with respect to reserves must also be applied to the large national deposit institutions, especially the postal savings.53 Of course, for these secondary banks of issue, the central bank reserves for their notes and deposits would be the equivalent of gold reserves. In those countries where checking accounts at private commercial banks play an important role in trade—notably the United States and England—the same obligation must be exacted from those banks also.

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

2. “Price Level” Stabilization

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

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

Nothing more will be said here concerning the fundamental absurdity of the concept of “stable purchasing power” in a changing economy. This has already been discussed at some length. For practical economic policy, the only problem is what inflationist or restrictionist measures to consider for the partial adjustment of severe price declines or increases. Such measures, carried out in stages, step by step, through piecemeal international agreements, would benefit either creditors or debtors. However, one question remains: Whether, in view of the conflicts among interests, agreements on this issue could be reached among nations.

The viewpoints of creditors and debtors will no doubt differ widely, and these conflicts of interest will complicate still more the manipulation of money internationally, than on the national level.

3. International Complications

It is also possible to consider monetary manipulation as an aspect of national economic policy, and take steps to regulate the value of money independently, without reference to the international situation. According to Keynes,54 if there is a choice between stabilization of prices and stabilization of the foreign exchange rate, the decision should be in favor of price stabilization and against stabilization of the rate of exchange. However, a nation which chose to proceed in this way would create international complications because of the repercussions its policy would have on the content of contractual obligations.

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

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

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

4. The Future

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

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

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

  • 28. [Lord Samuel Jones Loyd Overstone (1796–1883) was an early opponent of inconvertible paper money and a leading proponent of the principles of the Peel's Act of 1844.—Ed.]
  • 29. [See Theory and History (1957; 1969; Auburn, Ala.: Ludwig von Mises Institute, 1985).—Ed.]
  • 30. [Regarding the theories of William Stanley Jevons, Henry L. Moore and William Beveridge, see Wesley Clair Mitchell's Business Cycles (New York: National Bureau of Economic Research, 1927), pp. 12ff.—Ed.]
  • 31. As mentioned above, the most commonly used name for this theory is the “monetary theory.” For a number of reasons the designation “circulation credit theory” is preferable.
  • 32. If expressions such as cycle, wave, etc., are used in business cycle theory, they are merely illustrations to simplify the presentation. One cannot and should not expect more from a simile which, as such, must always fall short of reality.
  • 33. [For further explanation of the distinction between “commodity credit” and “circulation credit” see Mises's 1946 essay “The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money” included later in this volume, especially, pp. 193–94.—Ed.]
  • 34. [In 1928, fiduciary media were issued only by discounting what Mises called commodity bills, or short-term (90 days or less) bills of exchange endorsed by a buyer and a seller and constituting a lien on the goods sold.—Ed.]
  • 35. Albert Hahn and Joseph Schumpeter have given me credit for the expression “forced savings” or “compulsory savings.” See Hahn's article on “Credit” in Handwörterbuch der Staatswissenschaften (4th ed., vol. V, p. 951) and Schumpeter's The Theory of Economic Development (2nd German language ed., 1926 [English translation, Harvard University Press, 1934), p. 109n.]). To be sure, I described the phenomenon in 1912 in the first German language edition of The Theory of Money and Credit [see 1953, pp. 208ff. and 347ff.; 1980, pp. 238ff. and 385ff. of the English translations]. However, I do not believe the expression itself was actually used there.
  • 36. In the language of Knut Wicksell and the classical economists.
  • 37. I believe this should be pointed out here again, although I have exhausted everything to be said on the subject (pp. 105–07) and in The Theory of Money and Credit [1953, pp. 361ff.; 1980, pp. 400ff.]. Anyone who has followed the discussions of recent years will realize how important it is to stress these things again and again.
  • 38. To avoid misunderstanding, it should be pointed out that the expression “long-waves” of the trade cycle is not to be understood here as it was used by either Wilhelm Röpke or N.D. Kondratieff. Röpke (Die Konjunktur [Jena, 1922], p. 21) considered “long-wave cycles” to be those which lasted 5–10 years generally. Kondratieff (“Die langen Wellen der Konjunktur” in Archiv für Sozialwissenschaft 56, pp. 573ff.) tried to prove, unsuccessfully in my judgment, that, in addition to the 7–11 year cycles of business conditions which he called medium cycles, there were also regular cyclical waves averaging 50 years in length.
  • 39. [The German term, “Sanierungskrise,” means literally “restoration crisis,” i.e., the crisis which comes at the shift to more “healthy” monetary relationships. In English this crisis is called the “stabilization crisis.”—Ed.]
  • 40. Lord Samuel Jones Loyd Overstone, “Reflections Suggested by a Perusal of Mr. J. Horsley Palmer's Pamphlet on the Causes and Consequences of the Pressure on the Money Market,” 1837. (Reprinted in Tracts and Other Publications on Metallic and Paper Currency [London, 1857], p. 31.)
  • 41. 41 See Theorie des Geldes und der Umlaufsmittel (1912), pp. 433ff. I had been deeply impressed by the fact that Lord Overstone was also apparently inclined to this interpretation. See his “Reflections,” pp. 32ff. [NOTE: These paragraphs were deleted from the 2nd German edition (1924) from which was made the H.E. Batson English translation, The Theory of Money and Credit, published 1934, 1953, and 1971.—Ed.]
  • 42. William Douglass (1691–1752), a renowned physician, came to America in 1716. His “A Discourse Concerning the Currencies of the British Plantations in America” (1739) first appeared anonymously.
  • 43. [See the examples cited in The Theory of Money and Credit (pp. 387ff.; 1980, pp. 426ff.).—Ed.]
  • 44. Even the countries that have followed different procedures in this respect have, for all practical purposes, placed no obstacle in the way of the development of fiduciary media in the form of bank deposits.
  • 45. [According to Professor Mises, the “three European empires” were Austria-Hungary, Germany and Russia. This designation probably comes from the “Three Emperors’ League” (1872), an informal alliance among these governments. Its effectiveness was declining by 1890, and World War I dealt it a final blow.—Ed.]
  • 46. [Mises undoubtedly refers here to the way the Federal Reserve System reacted to the post World War I boom, when it brought an end to credit expansion by raising the discount rate, thus precipitating the 1920–1921 correction period, popularly called a “recession.”—Ed.]
  • 47. [Frédéric Bastiat (1801–1850) replied to an open letter addressed to him by an editor of Voix du Peuple (October 22, 1849). Then the Socialist, Pierre Jean Proudhon (1809–1865), answered. Proudhon, an advocate of unlimited monetary expansion by reduction of the interest rate to zero, and Bastiat, who favored moderate credit expansion and only a limited reduction of interest rates, carried on a lengthy exchange for several months, until March 7, 1850. (Oeuvres Completes de Frédéric Bastiat, 4th ed., vol. 5 [Paris, 1878], pp. 93–336.)—Ed.]
  • 48. This Harvard barometer was developed at the University by the Committee on Economic Research from three statistical series which are presumed to reveal (1) the extent of stock speculation, (2) the condition of industry and trade and (3) the supply of funds.
  • 49. [See above p. 41, note 26.—Ed.]
  • 50. [See above p. 68, note 11.—Ed.]
  • 51. Austria-Hungary, Germany, and Russia. [See above p. 130, note 45.—Ed.]
  • 52. Also, as a result of this, it became easier to distinguish crises originating from definite causes (wars and political upheavals, violent convulsions of nature, changes in the shape of supply or demand) from cyclically-recurring crises.
  • 53. [The Post Office Savings Institution, established in Austria in the 1880s and copied in several other European countries, played a significant, if limited, role in monetary affairs. See Mises's comments in Human Action, pp. 445–46.—Ed.]
  • 54. John Maynard Keynes, A Tract on Monetary Reform (London, 1923; New York, 1924), pp. 156ff.