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9

Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm

UNTIL THE YEARs 1973–1974, the Keynesians who had formed the ruling economic orthodoxy since the late 1930s had been riding high, wide, and handsome.1 Virtually everyone had accepted the Keynesian view that there is something in the free-market economy that makes it subject to swings of under- and overspending (in practice, the Keynesian concern is almost exclusively with alleged underspending), and that hence it is the function of the government to compensate for this market defect. The government was to compensate for this alleged imbalance by manipulating its spending and deficits (in practice, to increase them). Guiding this vital "macroeconomic" function of government, of course, was to be a board of Keynesian economists (the "Council of Economic Advisors"), who would be able to "fine-tune" the economy so as to prevent either inflation or recession, and to regulate the proper amount of total spending so as to insure continuing full employment without inflation.

It was in 1973–1974 that even the Keynesians finally realized that something was very, very wrong with this confident scenario, that it was time to go back in confusion to their drawing boards. For not only had forty-odd years of Keynesian fine-tuning not eliminated a chronic inflation that had set in with World War II, but it was in those years that inflation escalated temporarily into double-digit figures (to about 13% per annum). Not only that, it was also in 1973–1974 that the United States plunged into its deepest and longest recession since the 1930s (it would have been called a "depression" if the term hadn't long since been abandoned as impolitic by economists). This curious phenomenon of a vaunting inflation occurring at the same time as a steep recession was simply not supposed to happen in the Keynesian view of the world. Economists had always known that either the economy is in a boom period, in which case prices are rising, or else the economy is in a recession or depression marked by high unemployment, in which case prices are falling. In the boom, the Keynesian government was supposed to "sop up excess purchasing power" by increasing taxes, according to the Keynesian prescription—that is, it was supposed to take spending out of the economy; in the recession, on the other hand, the government was supposed to increase its spending and its deficits, in order to pump spending into the economy. But if the economy should be in an inflation and a recession with heavy unemployment at the same time, what in the world was government supposed to do? How could it step on the economic accelerator and brake at the same time?

As early as the recession of 1958, things had started to work peculiarly; for the first time, in the midst of a recession, consumer goods prices rose, if only slightly. It was a cloud no bigger than a man's hand, and it seemed to give Keynesians little to worry about.

Consumer prices, again, rose in the recession of 1966, but this was such a mild recession that no one worried about that either. The sharp inflation of the recession of 1969–1971, however, was a considerable jolt. But it took the steep recession that began in the midst of the double-digit inflation of 1973–1974 to throw the Keynesian economic establishment into permanent disarray. It made them realize that not only had fine-tuning failed, not only was the supposedly dead and buried cycle still with us, but now the economy was in a state of chronic inflation and getting worse—and it was also subject to continuing bouts of recession: of inflationary recession, or "stagflation." It was not only a new phenomenon, it was one that could not be explained, that could not even exist, in the theories of [economic orthodoxy}(/topic/economics).

And the inflation appeared to be getting worse: approximately 1–2% per annum in the Eisenhower years, up to 3–4% during the Kennedy era, to 5–6% in the Johnson administration, then up to about 13% in 1973–1974, and then falling "back" to about 6%, but only under the hammer blows of a steep and prolonged depression (approximately 1973–1976).

There are several things, then, which need almost desperately to be explained: (1) Why the chronic and accelerating inflation? (2) Why an inflation even during deep depressions? And while we are at it, it would be important to explain, if we could, (3) Why the business cycle at all? Why the seemingly unending round of boom and bust?

Fortunately, the answers to these questions are at hand, provided by the tragically neglected "Austrian School" of economics and its theory of the money and business cycle, developed in Austria by Ludwig von Mises and his follower Friedrich A. Hayek and brought to the London School of Economics by Hayek in the early 1930s. Actually, Hayek's Austrian business cycle theory swept the younger economists in Britain precisely because it alone offered a satisfactory explanation of the Great Depression of the 1930s. Such future Keynesian leaders as John R. Hicks, Abba P. Lerner, Lionel Robbins, and Nicholas Kaldor in England, as well as Alvin Hansen in the United States, had been Hayekians only a few years earlier. Then, Keynes's General Theory swept the boards after 1936 in a veritable "Keynesian Revolution," which arrogantly proclaimed that no one before it had presumed to offer any explanation whatever of the business cycle or of the Great Depression. It should be emphasized that the Keynesian theory did not win out by carefully debating and refuting the Austrian position; on the contrary, as often happens in the history of social science, Keynesianism simply became the new fashion, and the Austrian theory was not refuted but only ignored and forgotten.

For four decades, the Austrian theory was kept alive, unwept, unhonored, and unsung by most of the world of economics: only Mises (at NYU) and Hayek (at Chicago) themselves and a few followers still clung to the theory. Surely it is no accident that the current renaissance of Austrian economics has coincided with the phenomenon of stagflation and its consequent shattering of the Keynesian paradigm for all to see. In 1974 the first conference of Austrian School economists in decades was held at Royalton College in Vermont. Later that year, the economics profession was astounded by the Nobel Prize being awarded to Hayek. Since then, there have been notable Austrian conferences at the University of Hartford, at Windsor Castle in England, and at New York University, with even Hicks and Lerner showing signs of at least partially returning to their own long-neglected position. Regional conferences have been held on the East Coast, on the West Coast, in the Middle West, and in the Southwest. Books are being published in this field, and, perhaps most important, a number of extremely able graduate students and young professors devoted to Austrian economics have emerged and will undoubtedly be contributing a great deal in the future.

Money and Inflation

What, then, does this resurgent Austrian theory have to say about our problem?2 The first thing to point out is that inflation is not ineluctably built into the economy, nor is it a prerequisite for a growing and thriving world. During most of the nineteenth century (apart from the years of the War of 1812 and the Civil War), prices were falling, and yet the economy was growing and industrializing. Falling prices put no damper whatsoever on business or economic prosperity.

Thus, falling prices are apparently the normal functioning of a growing market economy. So how is it that the very idea of steadily falling prices is so counter to our experience that it seems a totally unrealistic dream-world? Why, since World War II, have prices gone up continuously, and even swiftly, in the United States and throughout the world? Before that point, prices had gone up steeply during World War I and World War II; in between, they fell slightly despite the great boom of the 1920s, and then fell steeply during the Great Depression of the 1930s. In short, apart from wartime experiences, the idea of inflation as a peacetime norm really arrived after World War II.

The favorite explanation of inflation is that greedy businessmen persist in putting up prices in order to increase their profits. But surely the quotient of business "greed" has not suddenly taken a great leap forward since World War II. Weren't businesses equally "greedy" in the nineteenth century and up to 1941? So why was there no inflation trend then? Moreover, if businessmen are so avaricious as to jack up prices 10% per year, why do they stop there? Why do they wait; why don't they raise prices by 50%, or double or triple them immediately? What holds them back?

A similar flaw rebuts another favorite explanation of inflation: that unions insist on higher wage rates, which in turn leads businessmen to raise prices. Apart from the fact that inflation appeared as long ago as ancient Rome and long before unions arrived on the scene, and apart from the lack of evidence that union wages go up faster than nonunion or that prices of unionized products rise faster than of nonunionized, a similar question arises: Why don't businesses raise their prices anyway? What is it that permits them to raise prices by a certain amount, but not by more? If unions are that powerful, and businesses that responsive, why don't wages and prices rise by 50%, or 100%, per year? What holds them back?

A government-inspired TV propaganda campaign a few years ago got a bit closer to the mark: consumers were blamed for inflation by being too "piggy," by eating and spending too much. We have here at least the beginning of an explanation of what holds businesses or unions back from demanding still higher prices: consumers won't pay them. Coffee prices zoomed upward a few years ago; a year or two later they fell sharply because of consumer resistance—to some extent from a flashy consumer "boycott"—but more importantly from a shift in consumer buying habits away from coffee and toward lower-priced substitutes. So a limit on consumer demand holds them hack.

But this pushes the problem one step backward. For if consumer demand, as seems logical, is limited at any given time, how come it keeps going up, year after year, and validating or permitting price and wage increases? And if it can go up by 10%, what keeps it from going up by 50%? In short, what enables consumer demand to keep going up, year after year, and yet keeps it from going up any further?

To go any further in this detective hunt we must analyze the meaning of the term "price." What exactly is a price? The price of any given quantity of a product is the amount of money the buyer must spend on it. In short, if someone must spend seven dollars on ten loaves of bread, then the "price" of those ten loaves is seven dollars, or, since we usually express price per unit of product, the price of bread is seventy cents per loaf. So there are two sides to this exchange: the buyer with money and the seller with bread. It should be clear that the interaction of both sides brings about the ruling price in the market. In short, if more bread comes onto the market, the price of bread will be bid down (increased supply lowers the price); while, on the other hand, if the bread buyers have more money in their wallets, the price of bread will be bid higher (increased demand raises the price).

We have now found the crucial element that limits and holds back the amount of consumer demand and hence the price: the amount of money in the consumers' possession. If the money in their pockets increases by 20%, then the limitation on their demand is relaxed by 20%, and, other things remaining equal, prices will tend to rise by 20% as well. We have found the crucial factor: the stock or the supply of money.

If we consider prices across-the-board for the entire economy, then the crucial factor is the total stock or supply of money in the whole economy. In fact, the importance of the money supply in analyzing inflation may be seen in extending our treatment from the bread or coffee market to the overall economy. For all prices are determined inversely by the supply of the good and directly by the demand for it. But the supplies of goods are, in general, going up year after year in our still growing economy. So that, from the point of view of the supply side of the equation, most prices should be falling, and we should right now be experiencing a nineteenth-century-style steady fall in prices ("deflation"). If chronic inflation were due to the supply side—to activities by producers such as business firms or unions—then the supply of goods overall would necessarily be falling, thereby raising prices. But since the supply of goods is manifestly increasing, the source of inflation must be the demand side—and the dominant factor on the demand side, as we have indicated, is the total supply of money.

And, indeed, if we look at the world past and present, we find that the money supply has been going up at a rapid pace. It rose in the nineteenth century, too, but at a much slower pace, far slower than the increase of goods and services; but, since World War II, the increase in the money supply—both here and abroad—has been much faster than in the supply of goods. Hence, inflation.

The crucial question then becomes who, or what, controls and determines the money supply, and keeps increasing its amount, especially in recent decades? To answer this question, we must first consider how money arises to begin with in the market economy. For money first arises on the market as individuals begin to choose one or several useful commodities to act as a money: the best money-commodities are those that are in high demand; that have a high value per unit-weight; that are durable, so they can be stored a long time, mobile, so they can be moved readily from one place to another, and easily recognizable; and that can be readily divisible into small parts without losing their value. Over the centuries, various markets and societies have chosen a large number of commodities as money: from salt to sugar to cowrie shells to cattle to tobacco down to cigarettes in POW camps during World War II. But over all these centuries, two commodities have always won out in the competitive race to become moneys when they have been available: gold and silver.

Metals always circulate by their weight—a ton of iron, a pound of copper, etc.—and their prices are reckoned in terms of these units of weight. Gold and silver are no exception. Every one of the modern currency units originated as units of weight of either gold or silver. Thus, the British unit, the "pound sterling," is so named because it originally meant simply one pound of silver. (To see how the pound has lost value in the centuries since, we should note that the pound sterling is now worth two-fifths of an ounce of silver on the market. This is the effect of British inflation—of the debasement of the value of the pound.) The "dollar" was originally a Bohemian coin consisting of an ounce of silver. Later on, the "dollar" came to be defined as one-twentieth of an ounce of gold.

When a society or a country comes to adopt a certain commodity as a money, and its unit of weight then becomes the unit of currency—the unit of reckoning in everyday life—then that country is said to be on that particular commodity "standard." Since markets have universally found gold or silver to be the best standards whenever they are available, the natural course of these economies is to be on the gold or silver standard. In that case, the supply of gold is determined by market forces: by the technological conditions of supply, the prices of other commodities, etc.

From the beginning of market adoption of gold and silver as money, the State has been moving in to seize control of the money-supply function, the function of determining and creating the supply of money in the society. It should be obvious why the State should want to do so: this would mean seizing control over the money supply from the market and turning it over to a group of people in charge of the State apparatus. Why they should want to do so is clear: here would be an alternative to taxation which the victims of a tax always consider onerous.

For now the rulers of the State can simply create their own money and spend it or lend it out to their favorite allies. None of this was easy until the discovery of the art of printing; after that, the State could contrive to change the definition of the "dollar," the "pound," the "mark," etc., from units of weight of gold or silver into simply the names for pieces of paper printed by the central government. Then that government could print them costlessly and virtually ad lib, and then spend or lend them out to its heart's content. It took centuries for this complex movement to be completed, but now the stock and the issuance of money is totally in the hands of every central government. The consequences are increasingly visible all around us.

Consider what would happen if the government should approach one group of people—say the Jones family—and say to them: "Here we give you the absolute and unlimited power to print dollars, to determine the number of dollars in circulation. And you will have an absolute monopoly power: anyone else who presumes to use such power will be jailed for a long, long time as an evil and subversive counterfeiter. We hope you use this power wisely." We can pretty well predict what the Jones family will do with this newfound power. At first, it will use the power slowly and carefully, to pay off its debts, perhaps buy itself a few particularly desired items; but then, habituated to the heady wine of being able to print their own currency, they will begin to use the power to the hilt, to buy luxuries, reward their friends, etc. The result will be continuing and even accelerated increases in the money supply, and therefore continuing and accelerated inflation.

But this is precisely what governments—all governments—have done. Except that instead of granting the monopoly power to counterfeit to the Jones or other families, government has "granted" the power to itself. Just as the State arrogates to itself a monopoly power over legalized kidnapping and calls it conscription; just as it has acquired a monopoly over legalized robbery and calls it taxation; so, too, it has acquired the monopoly power to counterfeit and calls it increasing the supply of dollars (or francs, marks, or whatever). Instead of a gold standard, instead of a money that emerges from and whose supply is determined by the free market, we are living under a fiat paper standard. That is, the dollar, franc, etc., are simply pieces of paper with such names stamped upon them, issued at will by the central government—by the State apparatus.

Furthermore, since the interest of a counterfeiter is to print as much money as he can get away with, so too will the State print as much money as it can get away with, just as it will employ the power to tax in the same way: to extract as much money as it can without raising too many howls of protest.

Government control of money supply is inherently inflationary, then, for the same reason that any system in which a group of people obtains control over the printing of money is bound to be inflationary.

The Federal Reserve and Fractional Reserve Banking

Inflating by simply printing more money, however, is now considered old-fashioned. For one thing, it is too visible; with a lot of high-denomination bills floating around, the public might get the troublesome idea that the cause of the unwelcome inflation is the government's printing of all the bills—and the government might be stripped of that power. Instead, governments have come up with a much more complex and sophisticated, and much less visible, means of doing the same thing: of organizing increases in the money supply to give themselves more money to spend and to subsidize favored political groups. The idea was this: instead of stressing the printing of money, retain the paper dollars or marks or francs as the basic money (the "legal tender"), and then pyramid on top of that a mysterious and invisible, but no less potent, "checkbook money," or bank demand deposits. The result is an inflationary engine, controlled by government, which no one but bankers, economists, and government central bankers understands—and designedly so.

First, it must be realized that the entire commercial banking system, in the United States or elsewhere, is under the total control of the central government—a control that the banks welcome, for it permits them to create money. The banks are under the complete control of the central bank—a government institution—a control stemming largely from the central bank's compulsory monopoly over the printing of money. In the United States, the Federal Reserve System performs this central banking function. The Federal Reserve ("the Fed") then permits the commercial banks to pyramid bank demand deposits ("checkbook money") on top of their own "reserves" (deposits at the Fed) by a multiple of approximately 6:1. In other words, if bank reserves at the Fed increase by $1 billion, the banks can and do pyramid their deposits by $6 billion—that is, the banks create $6 billion worth of new money.

Why do bank demand deposits constitute the major part of the money supply? Officially, they are not money or legal tender in the way that Federal Reserve Notes are money. But they constitute a promise by a bank that it will redeem its demand deposits in cash (Federal Reserve Notes) anytime that the depositholder (the owner of the "checking account") may desire. The point, of course, is that the banks don't have the money; they cannot, since they owe six times their reserves, which are their own checking account at the Fed. The public, however, is induced to trust the banks by the penumbra of soundness and sanctity laid about them by the Federal Reserve System. For the Fed can and does bail out banks in trouble. If the public understood the process and descended in a storm upon the banks demanding their money, the Fed, in a pinch, if it wanted, could always print enough money to tide the banks over.

The Fed, then, controls the rate of monetary inflation by adjusting the multiple (6:1) of bank money creation, or, more importantly, by determining the total amount of bank reserves. In other words, if the Fed wishes to increase the total money supply by $6 billion, instead of actually printing the $6 billion, it will contrive to increase bank reserves by $1 billion, and then leave it up to the banks to create $6 billion of new checkbook money. The public, meanwhile, is kept ignorant of the process or of its significance.

How do the banks create new deposits? Simply by lending them out in the process of creation. Suppose, for example, that the banks receive the $1 billion of new reserves; the banks will lend out $6 billion and create the new deposits in the course of making these new loans. In short, when the commercial banks lend money to an individual, a business firm, or the government, they are not relending existing money that the public laboriously had saved and deposited in their vaults—as the public usually believes. They lend out new demand deposits that they create in the course of the loan—and they are limited only by the "reserve requirements," by the required maximum multiple of deposit to reserves (e.g., 6:1). For, after all, they are not printing paper dollars or digging up pieces of gold; they are simply issuing deposit or "checkbook" claims upon themselves for cash—claims which they wouldn't have a prayer of honoring if the public as a whole should ever rise up at once and demand such a settling of their accounts.

How, then, does the Fed contrive to determine (almost always, to increase) the total reserves of the commercial banks? It can and does lend reserves to the banks, and it does so at an artificially cheap rate (the "rediscount rate"). But still, the banks do not like to be heavily in debt to the Fed, and so the total loans outstanding from the Fed to the banks is never very high. By far the most important route for the Fed's determining of total reserves is little known or understood by the public: the method of "open market purchases." What this simply means is that the Federal Reserve Bank goes out into the open market and buys an asset. Strictly, it doesn't matter what kind of an asset the Fed buys. It could, for example, be a pocket calculator for twenty dollars. Suppose that the Fed buys a pocket calculator from XYZ Electronics for twenty dollars. The Fed acquires a calculator; but the important point for our purposes is that XYZ Electronics acquires a check for twenty dollars from the Federal Reserve Bank. Now, the Fed is not open to checking accounts from private citizens, only from banks and the federal government itself. XYZ Electronics, therefore, can only do one thing with its twenty-dollar check: deposit it at its own bank, say the Acme Bank. At this point, another transaction takes place: XYZ gets an increase of twenty dollars in its checking account, in its "demand deposits." In return, Acme Bank gets a check, made over to itself, from the Federal Reserve Bank.

Now, the first thing that has happened is that XYZ's money stock has gone up by twenty dollars—its newly increased account at the Acme Bank—and nobody else's money stock has changed at all. So, at the end of this initial phase—phase I—the money supply has increased by twenty dollars, the same amount as the Fed's purchase of an asset. If one asks, where did the Fed get the twenty dollars to buy the calculator, then the answer is: it created the twenty dollars out of thin air by simply writing out a check upon itself. No one, neither the Fed nor anyone else, had the twenty dollars before it was created in the process of the Fed's expenditure.

But this is not all. For now the Acme Bank, to its delight, finds it has a check on the Federal Reserve. It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its "demand deposits with the Fed." Now that the banking system has an increase in $20, it can and does expand credit, that is, create more demand deposits in the form of loans to business (or to consumers or government), until the total increase in checkbook money is $120. At the end of phase II, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount, an increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others. The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.

In practice, of course, the Fed does not spend much of its time buying haphazard assets. Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset. In practice, this means purchases of U.S. government bonds and other U.S. government securities. The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase. For the government, this process also has the happy consequence of helping to prop up the government security market, and keep up the price of government bonds.

Suppose, however, that some bank, perhaps under the pressure of its depositors, might have to cash in some of its checking account reserves in order to acquire hard currency. What would happen to the Fed then, since its checks had created new bank reserves out of thin air? Wouldn't it be forced to go bankrupt or the equivalent? No, because the Fed has a monopoly on the printing of cash, and it could—and would—simply redeem its demand deposit by printing whatever Federal Reserve Notes are needed. In short, if a bank came to the Fed and demanded $20 in cash for its reserve—or, indeed, if it demanded $20 million—all the Fed would have to do is print that amount and pay it out. As we can see, being able to print its own money places the Fed in a uniquely enviable position.

So here we have, at long last, the key to the mystery of the modern inflationary process. It is a process of continually expanding the money supply through continuing Fed purchases of government securities on the open market. Let the Fed wish to increase the money supply by $6 billion, and it will purchase government securities on the open market to a total of $1 billion (if the money multiplier of demand deposits/reserves is 6:1) and the goal will be speedily accomplished. In fact, week after week, even as these lines are being read, the Fed goes into the open market in New York and purchases whatever amount of government bonds it has decided upon, and thereby helps decide upon the amount of monetary inflation.

The monetary history of this century has been one of repeated loosening of restraints on the State's propensity to inflate, the removal of one check after another until now the government is able to inflate the money supply, and therefore prices, at will. In 1913, the Federal Reserve System was created to enable this sophisticated pyramiding process to take place. The new system permitted a large expansion of the money supply, and of inflation to pay for war expenditures in World War I. In 1933, another fateful step was taken: the United States government took the country off the gold standard, that is, dollars, while still legally defined in terms of a weight of gold, were no longer redeemable in gold. In short, before 1933, there was an important shackle upon the Fed's ability to inflate and expand the money supply: Federal Reserve Notes themselves were payable in the equivalent weight of gold.

There is, of course, a crucial difference between gold and Federal Reserve Notes. The government cannot create new gold at will. Gold has to be dug, in a costly process, out of the ground. But Federal Reserve Notes can be issued at will, at virtually zero cost in resources. In 1933, the United States government removed the gold restraint on its inflationary potential by shifting to fiat money: to making the paper dollar itself the standard of money, with government the monopoly supplier of dollars. It was going off the gold standard that paved the way for the mighty U.S. money and price inflation during and after World War II.

But there was still one fly in the inflationary ointment, one restraint left on the U.S. government's propensity for inflation. While the United States had gone off gold domestically, it was still pledged to redeem any paper dollars (and ultimately bank dollars) held by foreign governments in gold should they desire to do so. We were, in short, still on a restricted and aborted form of gold standard internationally. Hence, as the United States inflated the money supply and prices in the 1950s and 1960s, the dollars and dollar claims (in paper and checkbook money) piled up in the hands of European governments. After a great deal of economic finagling and political arm-twisting to induce foreign governments not to exercise their right to redeem dollars in gold, the United States, in August 1971, declared national bankruptcy by repudiating its solemn contractual obligations and "closing the gold window." It is no coincidence that this tossing off of the last vestige of gold restraint upon the governments of the world was followed by the double-digit inflation of 1973–1974, and by similar inflation in the rest of the world.

We have now explained the chronic and worsening inflation in the contemporary world and in the United States: the unfortunate product of a continuing shift in this century from gold to government-issued paper as the standard money, and of the development of central banking and the pyramiding of checkbook money on top of inflated paper currency. Both interrelated developments amount to one thing: the seizure of control over the money supply by government.

If we have explained the problem of inflation, we have not yet examined the problem of the business cycle, of recessions, and of inflationary recession or stagflation. Why the business cycle, and why the new mysterious phenomenon of stagflation?

Bank Credit and the Business Cycle

The business cycle arrived in the Western world in the latter part of the eighteenth century. It was a curious phenomenon, because there seemed to be no reason for it, and indeed it had not existed before. The business cycle consisted of a regularly recurring (though not strictly periodical) series of booms and busts, of inflationary periods marked by increased business activity, higher employment, and higher prices followed sharply by recessions or depressions marked by declining business activity, higher unemployment, and price declines; and then, after a term of such recession, recovery takes place and the boom phase begins again.

A priori, there is no reason to expect this sort of cyclical pattern of economic activity. There will be cyclical waves in specific types of activity, of course; thus, the cycle of the seven-year locust will cause a seven-year cycle in locust-fighting activity, in the production of antilocust sprays and equipment, etc. But there is no reason to expect boom-bust cycles in the overall economy. In fact, there is reason to expect just the opposite; for usually the free market works smoothly and efficiently, and especially with no massive cluster of error such as becomes evident when boom turns suddenly to bust and severe losses are incurred. And indeed, before the late eighteenth century there were no such overall cycles. Generally, business went along smoothly and evenly until a sudden interruption occurred: a wheat famine would cause a collapse in an agricultural country; the king would seize most of the money in the hands of financiers, causing a sudden depression; a war would disrupt trading patterns. In each of these cases, there was a specific blow to trade brought about by an easily identifiable, one-shot cause, with no need to search further for explanation.

So why the new phenomenon of the business cycle? It was seen that the cycle occurred in the most economically advanced areas of each country: in the port cities, in the areas engaged in trade with the most advanced world centers of production and activity. Two different and vitally important phenomena began to emerge on a significant scale in Western Europe during this period, precisely in the most advanced centers of production and trade: industrialization and commercial banking. The commercial banking was the same sort of "fractional reserve" banking we have analyzed above, with London the site of the world's first central bank, the Bank of England, which originated at the turn of the eighteenth century. By the nineteenth century, in the new discipline of economics and among financial writers and commentators, two types of theories began to emerge in an attempt to explain the new and unwelcome phenomenon: those focussing the blame on the existence of industry, and those centering upon the banking system. The former, in sum, saw the responsibility for the business cycle to lie deep within the free-market economy—and it was easy for such economists to call either for the abolition of the market (e.g., Karl Marx) or for its drastic control and regulation by the government in order to alleviate the cycle (e.g., Lord Keynes). On the other hand, those economists who saw the fault to lie in the fractional reserve banking system placed the blame outside the market economy and onto an area—money and banking—which even English classical liberalism had never taken away from tight government control. Even in the nineteenth century, then, blaming the banks meant essentially blaming government for the boom-bust cycle.

We cannot go into details here on the numerous fallacies of the schools of thought that blame the market economy for the cycles; suffice it to say that these theories cannot explain the rise in prices in the boom or the fall in the recession, or the massive cluster of error that emerges suddenly in the form of severe losses when the boom turns to bust.

The first economists to develop a cycle theory centering on the money and banking system were the early nineteenth-century English classical economist David Ricardo and his followers, who developed the "monetary theory" of the business cycle.3 The Ricardian theory went somewhat as follows: the fractional-reserve banks, spurred and controlled by the government and its central bank, expand credit. As credit is expanded and pyramided on top of paper money and gold, the money supply (in the form of bank deposits or, in that historical period, bank notes) expands. The expansion of the money supply raises prices and sets the inflationary boom into motion. As the boom continues, fueled by the pyramiding of bank notes and deposits on top of gold, domestic prices also increase. But this means that domestic prices will be higher, and still higher, than the prices of imported goods, so that imports will increase and exports to foreign lands will decline. A deficit in the balance of payments will emerge and widen, and it will have to be paid for by gold flowing out of the inflating country and into the hard-money countries. But as gold flows out, the expanding money and banking pyramid will become increasingly top-heavy, and the banks will find themselves in increasing danger of going bankrupt. Finally, the government and banks will have to stop their expansion, and, to save themselves, the banks will have to contract their bank loans and checkbook money.

The sudden shift from bank credit expansion to contraction reverses the economic picture and bust quickly follows boom. The banks must pull in their horns, and businesses and economic activity suffer as the pressure mounts for debt repayment and contraction. The fall in the supply of money, in turn, leads to a general fall in prices ("deflation"). The recession or depression phase has arrived. However, as the money supply and prices fall, goods again become more competitive with foreign products and the balance of payments reverses itself, with a surplus replacing the deficit. Gold flows into the country, and, as bank notes and deposits contract on top of an expanding gold base, the condition of the banks becomes much sounder, and recovery gets under way.

The Ricardian theory had several notable features: It accounted for the behavior of prices by focussing on changes in the supply of bank money (which indeed always increased in booms and declined in busts). It also accounted for the behavior of the balance of payments. And, moreover, it linked the boom and the bust, so that the bust was seen to be the consequence of the preceding boom. And not only the consequence, but the salutary means of adjusting the economy to the unwise intervention that created the inflationary boom.

In short, for the first time, the bust was seen to be neither a visitation from hell nor a catastrophe generated by the inner workings of the industrialized market economy. The Ricardians realized that the major evil was the preceding inflationary boom caused by government intervention in the money and banking system, and that the recession, unwelcome though its symptoms may be, is really the necessary adjustment process by which that interventionary boom gets washed out of the economic system. The depression is the process by which the market economy adjusts, throws off the excesses and distortions of the inflationary boom, and reestablishes a sound economic condition. The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom.

Why, then, does the business cycle recur? Why does the next boom-and-bust cycle always begin? To answer that, we have to understand the motivations of the banks and the government. The commercial banks live and profit by expanding credit and by creating a new money supply; so they are naturally inclined to do so, "to monetize credit," if they can. The government also wishes to inflate, both to expand its own revenue (either by printing money or so that the banking system can finance government deficits) and to subsidize favored economic and political groups through a boom and cheap credit. So we know why the initial boom began. The government and the banks had to retreat when disaster threatened and the crisis point had arrived. But as gold flows into the country, the condition of the banks becomes sounder. And when the banks have pretty well recovered, they are then in the confident position to resume their natural tendency of inflating the supply of money and credit. And so the next boom proceeds on its way, sowing the seeds for the next inevitable bust.

Thus, the Ricardian theory also explained the continuing recurrence of the business cycle. But two things it did not explain. First, and most important, it did not explain the massive cluster of error that businessmen are suddenly seen to have made when the crisis hits and bust follows boom. For businessmen are trained to be successful forecasters, and it is not like them to make a sudden cluster of grave error that forces them to experience widespread and severe losses. Second, another important feature of every business cycle has been the fact that both booms and busts have been much more severe in the "capital goods industries" (the industries making machines, equipment, plant or industrial raw materials) than in consumer goods industries. And the Ricardian theory had no way of explaining this feature of the cycle.

The Austrian, or Misesian, theory of the business cycle built on the Ricardian analysis and developed its own "monetary overinvestment" or, more strictly, "monetary malinvestment" theory of the business cycle. The Austrian theory was able to explain not only the phenomena explicated by the Ricardians, but also the cluster of error and the greater intensity of capital goods' cycles. And, as we shall see, it is the only one that can comprehend the modern phenomenon of stagflation.

Mises begins as did the Ricardians: government and its central bank stimulate bank credit expansion by purchasing assets and thereby increasing bank reserves. The banks proceed to expand credit and hence the nation's money supply in the form of checking deposits (private bank notes having virtually disappeared). As with the Ricardians, Mises sees that this expansion of bank money drives up prices and causes inflation.

But, as Mises pointed out, the Ricardians understated the unfortunate consequences of bank credit inflation. For something even more sinister is at work. Bank credit expansion not only raises prices, it also artificially lowers the rate of interest, and thereby sends misleading signals to businessmen, causing them to make unsound and uneconomic investments.

For, on the free and unhampered market, the interest rate on loans is determined solely by the "time preferences" of all the individuals that make up the market economy. For the essence of any loan is that a "present good" (money which can be used at present) is being exchanged for a "future good" (an IOU which can be used at some point in the future). Since people always prefer having money right now to the present prospect of getting the same amount of money at some point in the future, present goods always command a premium over future goods in the market. That premium, or "agio," is the interest rate, and its height will vary according to the degree to which people prefer the present to the future, i.e., the degree of their time preferences.

People's time preferences also determine the extent to which people will save and invest for future use, as compared to how much they will consume now. If people's time preferences should fall, i.e., if their degree of preference for present over future declines, then people will tend to consume less now and save and invest more; at the same time, and for the same reason, the rate of interest, the rate of time-discount, will also fall. Economic growth comes about largely as the result of falling rates of time preference, which bring about an increase in the proportion of saving and investment to consumption, as well as a falling rate of interest.

But what happens when the rate of interest falls not because of voluntary lower time preferences and higher savings on the part of the public, but from government interference that promotes the expansion of bank credit and bank money? For the new checkbook money created in the course of bank loans to business will come onto the market as a supplier of loans, and will therefore, at least initially, lower the rate of interest. What happens, in other words, when the rate of interest falls artificially, due to intervention, rather than naturally, from changes in the valuations and preferences of the consuming public?

What happens is trouble. For businessmen, seeing the rate of interest fall, will react as they always must to such a change of market signals: they will invest more in capital goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable, now seem profitable because of the fall in the interest charge. In short, businessmen react as they would have if savings had genuinely increased: they move to invest those supposed savings. They expand their investment in durable equipment, in capital goods, in industrial raw material, and in construction, as compared with their direct production of consumer goods.

Thus, businesses happily borrow the newly expanded bank money that is coming to them at cheaper rates; they use the money to invest in capital goods, and eventually this money gets paid out in higher wages to workers in the capital goods industries. The increased business demand bids up labor costs, but businesses think they will be able to pay these higher costs because they have been fooled by the government-and-bank intervention in the loan market and by its vitally important tampering with the interest-rate signal of the marketplace—the signal that determines how many resources will be devoted to the production of capital goods and how many to consumer goods.

Problems surface when the workers begin to spend the new bank money that they have received in the form of higher wages. For the time preferences of the public have not really gotten lower; the public doesn't want to save more than it has. So the workers set about to consume most of their new income, in short, to reestablish their old consumer/saving proportions. This means that they now redirect spending in the economy back to the consumer goods industries, and that they don't save and invest enough to buy the newly produced machines, capital equipment, industrial raw materials, etc. This lack of enough saving-and-investment to buy all the new capital goods at expected and existing prices reveals itself as a sudden, sharp depression in the capital goods industries. For once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term "monetary overinvestment theory"), and had also underinvested in consumer goods. Business had been seduced by the governmental tampering and artificial lowering of the rate of interest and acted as if more savings were available to invest than were really there. As soon as the new bank money filtered through the system and the consumers reestablish their old time-preference proportions, it became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available ("monetary malinvestment theory"). Business had overinvested in capital goods and underinvested in consumer goods.

The inflationary boom thus leads to distortions of the pricing and production system. Prices of labor, raw materials, and machines in the capital goods industries are bid up too high during the boom to be profitable once the consumers are able to reassert their old consumption/investment preferences. The "depression" is thus seen—even more than in the Ricardian theory—as the necessary and healthy period in which the market economy sloughs off and liquidates the unsound, uneconomic investments of the boom, and reestablishes those proportions between consumption and investment that are truly desired by the consumers. The depression is the painful but necessary process by which the free market rids itself of the excesses and errors of the boom and reestablishes the market economy in its function of efficient service to the mass of consumers. Since the prices of factors of production (land, labor, machines, raw materials) have been bid too high in the capital goods industries during the boom, this means that these prices must be allowed to fall in the recession until proper market proportions of prices and production are restored.

Put another way, the inflationary boom will not only increase prices in general, it will also distort relative prices, will distort relations of one type of price to another. In brief, inflationary credit expansion will raise all prices; but prices and wages in the capital goods industries will go up faster than the prices of consumer goods industries. In short, the boom will be more intense in the capital goods than in the consumer goods industries. On the other hand, the essence of the depression adjustment period will be to lower prices and wages in the capital goods industries relative to consumer goods, in order to induce resources to move back from the swollen capital goods to the deprived consumer goods industries. All prices will fall because of the contraction of bank credit, but prices and wages in capital goods will fall more sharply than in consumer goods. In short, both the boom and the bust will be more intense in the capital than in the consumer goods industries. Hence, we have explained the greater intensity of business cycles in the former type of industry.

There seems to be a flaw in the theory, however; for, since workers receive the increased money in the form of higher wages fairly rapidly, and then begin to reassert their desired consumer/investment proportions, how is it that booms go on for years without facing retribution: without having their unsound investments revealed or their errors caused by bank tampering with market signals made evident? In short, why does it take so long for the depression adjustment process to begin its work? The answer is that the booms would indeed be very short-lived (say, a few months) if the bank credit expansion and the subsequent pushing of interest rates below the free-market level were just a one-shot affair. But the crucial point is that the credit expansion is not one shot. It proceeds on and on, never giving the consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in cost in the capital goods industries to catch up to the inflationary rise in prices. Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance by repeated and accelerating doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop or sharply slow down, either because the banks are getting shaky or because the public is getting restive at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, the piper must be paid, and the inevitable readjustments must liquidate the unsound over-investments of the boom and redirect the economy more toward consumer goods production. And, of course, the longer the boom is kept going, the greater the malinvestments that must be liquidated, and the more harrowing the readjustments that must be made.

Thus, the Austrian theory accounts for the massive cluster of error (overinvestments in capital goods industries suddenly revealed as such by the stopping of the artificial stimulant of credit expansion) and for the greater intensity of boom and bust in the capital goods than in the consumer goods industries. Its explanation for the recurrence, for the inauguration of the next boom, is similar to the Ricardian; once the liquidations and bankruptcies are undergone, and the price and production adjustments completed, the economy and the banks begin to recover, and the banks can set themselves to return to their natural and desired course of credit expansion.

What of the Austrian explanation—the only proferred explanation— of stagflation? How is it that, in recent recessions, prices continue to go up? We must amend this first by pointing out that it is particularly consumer goods prices that continue to rise during recessions, and that confound the public by giving them the worst of both worlds at the same time: high unemployment and increases in the cost of living. Thus, during the most recent 1974–1976 depression, consumer goods prices rose rapidly, but wholesale prices remained level, while industrial raw material prices fell rapidly and substantially. So how is it that the cost of living continues to rise in current recessions?

Let us go back and examine what happened to prices in the "classic," or old-fashioned boom-bust cycle (pre-World War II vintage), in the booms the money supply went up, prices in general therefore went up, but the prices of capital goods rose by more than consumer goods, drawing resources out of consumer and into capital goods industries. In short, abstracting from general price increases, relative to each other, capital goods prices rose and consumer prices fell in the boom. What happened in the bust? The opposite situation: the money supply went down, prices in general therefore fell, but the prices of capital goods fell by more than consumer goods, drawing resources back out of capital goods into consumer goods industries. In short, abstracting from general price declines, relative to each other, capital goods prices fell and consumer prices rose during the bust.

The Austrian point is that this scenario in relative prices in boom and bust is still taking place unchanged. During the booms, capital goods prices still rise and consumer goods prices still fall relative to each other, and vice versa during the recession. The difference is that a new monetary world has arrived, as we have indicated earlier in this chapter. For now that the gold standard has been eliminated, the Fed can and does increase the money supply all the time, whether it be boom or recession. There hasn't been a contraction of the money supply since the early 1930s, and there is not likely to be another in the foreseeable future. So now that the money supply always increases, prices in general are always going up, sometimes more slowly, sometimes more rapidly.

In short, in the classic recession, consumer goods prices were always going up relative to capital goods. Thus, if consumer goods prices fell by 10% in a particular recession, and capital goods prices fell by 30%, consumer prices were rising substantially in relative terms. But, from the point of view of the consumer, the fall in the cost of living was highly welcome, and indeed was the blessed sugarcoating on the pill of recession or depression. Even in the Great Depression of the 1930s, with very high rates of unemployment, the 75–80% of the labor force still employed enjoyed bargain prices for their consumer goods.

But now, with Keynesian fine-tuning at work, the sugarcoating has been removed from the pill. Now that the supply of money—and hence general prices—is never allowed to fall, the rise in relative consumer goods prices during a recession will hit the consumer as a visible rise in nominal prices as well. His cost of living now goes up in a depression, and so he reaps the worst of both worlds; in the classical business cycle, before the rule of Keynes and the Council of Economic Advisors, he at least had to suffer only one calamity at a time.

What then are the policy conclusions that arise rapidly and easily from the Austrian analysis of the business cycle? They are the precise opposite from those of the Keynesian establishment. For, since the virus of distortion of production and prices stems from inflationary bank credit expansion, the Austrian prescription for the business cycle will be: First, if we are in a boom period, the government and its banks must cease inflating immediately. It is true that this cessation of artificial stimulant will inevitably bring the inflationary boom to an end, and will inaugurate the inevitable recession or depression. But the longer the government delays this process, the harsher the necessary readjustments will have to be. For the sooner the depression readjustment is gotten over with, the better. This also means that the government must never try to delay the depression process; the depression must be allowed to work itself out as quickly as possible, so that real recovery can begin. This means, too, that the government must particularly avoid any of the interventions so dear to Keynesian hearts. It must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. For doing so will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices, especially in the capital goods industries; doing so will prolong and delay indefinitely the completion of the depression adjustment process. It will also cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again in order to get out of the depression. For even if this reinflation succeeds (which is by no means assured), it will only sow greater trouble and more prolonged and renewed depression later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio—when the only thing that could speed up the adjustment process is to lower the consumption/savings ratio so that more of the currently unsound investments will become validated and become economic. The only way the government can aid in this process is to lower its own budget, which will increase the ratio of investment to consumption in the economy (since government spending may be regarded as consumption spending for bureaucrats and politicians).

Thus, what the government should do, according to the Austrian analysis of the depression and the business cycle, is absolutely nothing. It should stop its own inflating, and then it should maintain a strict hands-off, laissez-faire policy. Anything it does will delay and obstruct the adjustment processes of the market; the less it does, the more rapidly will the market adjustment process do its work and sound economic recovery ensue.

The Austrian prescription for a depression is thus the diametric opposite of the Keynesian: it is for the government to keep absolute hands off the economy, and to confine itself to stopping its own inflation, and to cutting its own budget.

It should be clear that the Austrian analysis of the business cycle meshes handsomely with the libertarian outlook toward government and a free economy. Since the State would always like to inflate and to interfere in the economy, a libertarian prescription would stress the importance of absolute separation of money and banking from the State. This would involve, at the very least, the abolition of the Federal Reserve System and the return to a commodity money (e.g., gold or silver) so that the money-unit would once again be a unit of weight of a market-produced commodity rather than the name of a piece of paper printed by the State's counterfeiting apparatus.


  1. Keynesians are creators of "macroeconomics" and disciples of Lord Keynes, the wealthy and charismatic Cambridge University economist whose General Theory of Employment, Interest, and Money (New York: Harcourt Brace, 1936) is the cornerstone of Keynesian economics. ↩︎

  2. A brief introduction to Austrian business cycle theory can be found in Murray N. Rothbard, Depressions: Their Cause and Cure (Lansing, Mich.: Constitutional Alliance, March 1969). The theory is set forth and then applied to the Great Depression of 1929-1933, and also used briefly to explain our current stagflation, in Rothbard, America's Great Depression, 3rd ed. (Kansas City, Kans.: Sheed and Ward, 1975).
    The best source for the Austrian theory of money is still its original work: Ludwig von Mises, Theory of Money and Credit, 3rd ed. (Irvington-on Hudson, N.Y.: Foundation for Economic Education, 1971). For an introduction, see Rothbard, What Has Government Done to Our Money? 2nd ed. (Los Angeles: Libertarian Publishers, 1974). ↩︎

  3. For the analysis of the remainder of this chapter, see Rothbard, Depressions: Their Cause and Cure, pp. 13-26. ↩︎