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B. Credit Expansion and the Business Cycle
We have already seen in chapter 8 what happens when there is net saving-investment: an increase in the ratio of gross investment to consumption in the economy. Consumption expenditures fall, and the prices of consumers’ goods fall. On the other hand, the production structure is lengthened, and the prices of original factors specialized in the higher stages rise. The prices of capital goods change like a lever being pivoted on a fulcrum at its center; the prices of consumers’ goods fall most, those of first-order capital goods fall less; those of highest-order capital goods rise most, and the others less. Thus, the price differentials between the stages of production all diminish. Prices of original factors fall in the lower stages and rise in the higher stages, and the nonspecific original factors (mainly labor) shift partly from the lower to the higher stages. Investment tends to be centered in lengthier processes of production. The drop in price differentials is, as we have seen, equivalent to a fall in the natural rate of interest, which, of course, leads to a corollary drop in the loan rate. After a while the fruit of the more productive techniques arrives; and the real income of everyone rises.
Thus, an increase in saving resulting from a fall in time preferences leads to a fall in the interest rate and another stable equilibrium situation with a longer and narrower production structure. What happens, however, when the increase in investment is not due to a change in time preference and saving, but to credit expansion by the commercial banks? Is this a magic way of expanding the capital structure easily and costlessly, without reducing present consumption? Suppose that six million gold ounces are being invested, and four million consumed, in a certain period of time. Suppose, now, that the banks in the economy expand credit and increase the money supply by two million ounces. What are the consequences? The new money is loaned to businesses.110 These businesses, now able to acquire the money at a lower rate of interest, enter the capital goods’ and original factors’ market to bid resources away from the other firms. At any given time, the stock of goods is fixed, and the two million new ounces are therefore employed in raising the prices of producers’ goods. The rise in prices of capital goods will be imputed to rises in original factors.
The credit expansion reduces the market rate of interest. This means that price differentials are lowered, and, as we have seen in chapter 8, lower price differentials raise prices in the highest stages of production, shifting resources to these stages and also increasing the number of stages. As a result, the production structure is lengthened. The borrowing firms are led to believe that enough funds are available to permit them to embark on projects formerly unprofitable. On the free market, investment will always take place first in those projects that satisfy the most urgent wants of the consumers. Then the next most urgent wants are satisfied, etc. The interest rate regulates the temporal order of choice of projects in accordance with their urgency. A lower rate of interest on the market is a signal that more projects can be undertaken profitably. Increased saving on the free market leads to a stable equilibrium of production at a lower rate of interest. But not so with credit expansion: for the original factors now receive increased money income. In the free-market example, total money incomes remained the same. The increased expenditure on higher stages was offset by decreased expenditure in the lower stages. The “increased length” of the production structure was compensated by the “reduced width.” But credit expansion pumps new money into the production structure: aggregate money incomes increase instead of remaining the same. The production structure has lengthened, but it has also remained as wide, without contraction of consumption expenditure.
The owners of the original factors, with their increased money income, naturally hasten to spend their new money. They allocate this spending between consumption and investment in accordance with their time preferences. Let us assume that the time-preference schedules of the people remain unchanged. This is a proper assumption, since there is no reason to assume that they have changed because of the inflation. Production now no longer reflects voluntary time preferences. Business has been led by credit expansion to invest in higher stages, as if more savings were available. Since they are not, business has overinvested in the higher stages and underinvested in the lower. Consumers act promptly to re-establish their time preferences—their preferred investment/consumption proportions and price differentials. The differentials will be re-established at the old, higher amount, i.e., the rate of interest will return to its free-market magnitude. As a result, the prices at the higher stages of production will fall drastically, the prices at the lower stages will rise again, and the entire new investment at the higher stages will have to be abandoned or sacrificed.
Altering our oversimplified example, which has treated only two stages, we see that the highest stages, believed profitable, have proved to be unprofitable. The pure rate of interest, reflecting consumer desires, is shown to have really been higher all along. The banks’ credit expansion had tampered with that indispensable “signal”—the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable. In the free market the interest rate is an indispensable guide, in the time dimension, to the urgency of consumer wants. But bank intervention in the market disrupts this free price and renders entrepreneurs unable to satisfy consumer desires properly or to estimate the most beneficial time structure of production. As soon as the consumers are able, i.e., as soon as the increased money enters their hands, they take the opportunity to re-establish their time preferences and therefore the old differentials and investment-consumption ratios. Overinvestment in the highest stages, and underinvestment in the lower stages are now revealed in all their starkness. The situation is analogous to that of a contractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation (the higher stages), with no material left to complete the house.111 Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.
It should not be surprising that the market tends to revert to its preferred ratios. The same process, as we have seen, takes place in all prices after a change in the money stock. Increased money always begins in one area of the economy, raising prices there, and filters and diffuses eventually over the whole economy, which then roughly returns to an equilibrium pattern conforming to the value of the money. If the market then tends to return to its preferred price-ratios after a change in the money supply, it should be evident that this includes a return to its preferred saving-investment ratio, reflecting social time preferences.
It is true, of course, that time preferences may alter in the interim, either for each individual or as a result of the redistribution during the change. The gainers may save more or less than the losers would have done. Therefore, the market will not return precisely to the old free-market interest rate and investment/consumption ratio, just as it will not return to its precise pattern of prices. It will revert to whatever the free-market interest rate is now, as determined by current time preferences. Some advocates of coercing the market into saving and investing more than it wishes have hailed credit expansion as leading to “forced saving,” thereby increasing the capital-goods structure. But this can happen, not as a direct consequence of credit expansion, but only because effective time preferences have changed in that direction (i.e., time-preference schedules have shifted, or relatively more money is now in the hands of those with low time preferences). Credit expansion may well lead to the opposite effect: the gainers may have higher time preferences, in which case the free-market interest rate will be higher than before. Because these effects of credit expansion are completely uncertain and depend on the concrete data of each particular case, it is clearly far more cogent for advocates of forced saving to use the taxation process to make their redistribution.
The market therefore reacts to a distortion of the free-market interest rate by proceeding to revert to that very rate. The distortion caused by credit expansion deceives businessmen into believing that more savings are available and causes them to malinvest—to invest in projects that will turn out to be unprofitable when consumers have a chance to reassert their true preferences. This reassertion takes place fairly quickly—as soon as owners of factors receive their increased incomes and spend them.
This theory permits us to resolve an age-old controversy among economists: whether an increase in the money supply can lower the market rate of interest. To the mercantilists—and to the Keynesians—it was obvious that an increased money stock permanently lowered the rate of interest (given the demand for money). To the classicists it was obvious that changes in the money stock could affect only the value of the monetary unit, and not the rate of interest. The answer is that an increase in the supply of money does lower the rate of interest when it enters the market as credit expansion, but only temporarily. In the long run (and this long run is not very “long”), the market re-establishes the free-market time-preference interest rate and eliminates the change. In the long run a change in the money stock affects only the value of the monetary unit.
This process—by which the market reverts to its preferred interest rate and eliminates the distortion caused by credit expansion—is, moreover, the business cycle! Our analysis therefore permits the solution, not only of the theoretical problem of the relation between money and interest, but also of the problem that has plagued society for the last century and a half and more—the dread business cycle. And, furthermore, the theory of the business cycle can now be explained as a subdivision of our general theory of the economy.
Note the hallmarks of this distortion-reversion process. First, the money supply increases through credit expansion; then businesses are tempted to malinvest—overinvesting in higher-stage and durable production processes. Next, the prices and incomes of original factors increase and consumption increases, and businesses realize that the higher-stage investments have been wasteful and unprofitable. The first stage is the chief landmark of the “boom”; the second stage—the discovery of the wasteful malinvestments—is the “crisis.” The depression is the next stage, during which malinvested businesses become bankrupt, and original factors must suddenly shift back to the lower stages of production. The liquidation of unsound businesses, the “idle capacity” of the malinvested plant, and the “frictional” unemployment of original factors that must suddenly and en masse shift to lower stages of production—these are the chief hallmarks of the depression stage.
We have seen in chapter 11 that the major unexplained features of the business cycle are the mass of error and the concentration of error and disturbance in the capital-goods industries. Our theory of the business cycle solves both of these problems. The cluster of error suddenly revealed by entrepreneurs is due to the interventionary distortion of a key market signal—the interest rate. The concentration of disturbance in the capital-goods industries is explained by the spur to unprofitable higher-order investments in the boom period. And we have just seen that other characteristics of the business cycle are explained by this theory.
One point should be stressed: the depression phase is actually the recovery phase. Most people would be happy to keep the boom period, where the inflationary gains are visible and the losses hidden and obscure. This boom euphoria is heightened by the capital consumption that inflation promotes through illusory accounting profits. The stages that people complain about are the crisis and depression. But the latter periods, it should be clear, do not cause the trouble. The trouble occurs during the boom, when malinvestments and distortions take place; the crisis-depression phase is the curative period, after people have been forced to recognize the malinvestments that have occurred. The depression period, therefore, is the necessary recovery period; it is the time when bad investments are liquidated and mistaken entrepreneurs leave the market—the time when “consumer sovereignty” and the free market reassert themselves and establish once again an economy that benefits every participant to the maximum degree. The depression period ends when the free-market equilibrium has been restored and expansionary distortion eliminated.
It should be clear that any governmental interference with the depression process can only prolong it, thus making things worse from almost everyone's point of view. Since the depression process is the recovery process, any halting or slowing down of the process impedes the advent of recovery. The depression readjustments must work themselves out before recovery can be complete. The more these readjustments are delayed, the longer the depression will have to last, and the longer complete recovery is postponed. For example, if the government keeps wage rates up, it brings about permanent unemployment. If it keeps prices up, it brings about unsold surplus. And if it spurs credit expansion again, then new malinvestment and later depressions are spawned.
Many nineteenth-century economists referred to the business cycle in a biological metaphor, likening the depression to a painful but necessary curative of the alcoholic or narcotic jag which is the boom, and asserting that any tampering with the depression delays recovery. They have been widely ridiculed by present-day economists. The ridicule is misdirected, however, for the biological analogy is in this case correct.
One obvious conclusion from our analysis is the absurdity of the “underconsumptionist” remedies for depression—the idea that the crisis is caused by underconsumption and that the way to cure the depression is to stimulate consumption expenditures. The reverse is clearly the truth. What has brought about the crisis is precisely the fact that entrepreneurial investment erroneously anticipated greater savings, and that this error is revealed by consumers’ re-establishing their desired proportion of consumption. “Overconsumption” or “undersaving” has brought about the crisis, although it is hardly fair to pin the guilt on the consumer, who is simply trying to restore his preferences after the market has been distorted by bank credit. The only way to hasten the curative process of the depression is for people to save and invest more and consume less, thereby finally justifying some of the malinvestments and mitigating the adjustments that have to be made.
One problem has been left unexplained. We have seen that the reversion period is short and that factor incomes increase rather quickly and start restoring the free-market consumption/saving ratios. But why do booms, historically, continue for several years? What delays the reversion process? The answer is that as the boom begins to peter out from an injection of credit expansion, the banks inject a further dose. In short, the only way to avert the onset of the depression-adjustment process is to continue inflating money and credit. For only continual doses of new money on the credit market will keep the boom going and the new stages profitable. Furthermore, only ever increasing doses can step up the boom, can lower interest rates further, and expand the production structure, for as the prices rise, more and more money will be needed to perform the same amount of work. Once the credit expansion stops, the market ratios are reestablished, and the seemingly glorious new investments turn out to be malinvestments, built on a foundation of sand.
How long booms can be kept up, what limits there are to booms in different circumstances, will be discussed below. But it is clear that prolonging the boom by ever larger doses of credit expansion will have only one result: to make the inevitably ensuing depression longer and more grueling. The larger the scope of malinvestment and error in the boom, the greater and longer the task of readjustment in the depression. The way to prevent a depression, then, is simple: avoid starting a boom. And to avoid starting a boom all that is necessary is to pursue a truly free-market policy in money, i.e., a policy of 100-percent specie reserves for banks and governments.
Credit expansion always generates the business cycle process, even when other tendencies cloak its workings. Thus, many people believe that all is well if prices do not rise or if the actually recorded interest rate does not fall. But prices may well not rise because of some counteracting force—such as an increase in the supply of goods or a rise in the demand for money. But this does not mean that the boom-depression cycle fails to occur. The essential processes of the boom—distorted interest rates, malinvestments, bankruptcies, etc.—continue unchecked. This is one of the reasons why those who approach business cycles from a statistical point of view and try in that way to arrive at a theory are in hopeless error. Any historical-statistical fact is a complex resultant of many causal influences and cannot be used as a simple element with which to construct a causal theory. The point is that credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle. Similarly, credit expansion does not necessarily lower the interest rate below the rate previously recorded; it lowers the rate below what it would have been in the free market and thus creates distortion and malinvestment. Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate. An increase in prices, as we have seen, generates a positive purchasing-power component in the natural interest rate, i.e., the rate of return earned by businessmen on the market. In the free market this would quickly be reflected in the loan rate, which, as we have seen above, is completely dependent on the natural rate. But a continual influx of circulating credit prevents the loan rate from catching up with the natural rate, and thereby generates the business-cycle process.112 A further corollary of this bank-created discrepancy between the loan rate and the natural rate is that creditors on the loan market suffer losses for the benefit of their debtors: the capitalists on the stock market or those who own their own businesses. The latter gain during the boom by the differential between the loan rate and the natural rate, while the creditors (apart from banks, which create their own money) lose to the same extent.
After the boom period is over, what is to be done with the malinvestments? The answer depends on their profitability for further use, i.e., on the degree of error that was committed. Some malinvestments will have to be abandoned, since their earnings from consumer demand will not even cover the current costs of their operation. Others, though monuments of failure, will be able to yield a profit over current costs, although it will not pay to replace them as they wear out. Temporarily working them fulfills the economic principle of always making the best of even a bad bargain.
Because of the malinvestments, however, the boom always leads to general impoverishment, i.e., reduces the standard of living below what it would have been in the absence of the boom. For the credit expansion has caused the squandering of scarce resources and scarce capital. Some resources have been completely wasted, and even those malinvestments that continue in use will satisfy consumers less than would have been the case without the credit expansion.
- 110. To the extent that the new money is loaned to consumers rather than businesses, the cycle effects discussed in this section do not occur.
- 111. See Mises, Human Action, p. 557.
- 112. Since Knut Wicksell is one of the fathers of this business-cycle approach, it is important to stress that our usage of “natural rate” differs from his. Wicksell's “natural rate” was akin to our “free-market rate”; our “natural rate” is the rate of return earned by businesses on the existing market without considering loan interest. It corresponds to what has been misleadingly called the “normal profit rate,” but is actually the basic rate of interest. See chapter 6 above.