Fractional-Reserve Banking and Business Cycles

Mises's careful distinction between money proper and money substitutes naturally led to the question of the role of money substitutes. In the second part of his book, Mises showed that bank-issued money substitutes could not affect the value and purchasing power of money, as well as the distribution and allocation of resources as long as they were true representatives of a corresponding amount of money deposited with the bank—that is, in Mises's terminology, as long as they were money certificates. Only if they were issued without being backed 100 percent by a money deposit could they have an influence on prices, distribution, and allocation. These issuances of uncovered or partially covered money substitutes—fiduciary media—added to the quantity of money in the larger sense, increasing money prices and redistributing resources in favor of their first recipients and at the expense of their last recipients. It was therefore necessary to single them out for separate analysis, inquiring after the particular consequences of an expansion of fiduciary media rather than of money proper. The last third of Theory of Money and Credit deals with this issue.

First Mises showed why fiduciary media had an impact on money prices. Although they are only legal documents, they are dealt with—bought and sold—as if they were real money, whether or not they are backed by real money. As a consequence, an increase in the quantity of fiduciary media leads to an increase of the price level in the same way and for the same reasons that an increase of real money has this effect.

Moreover, there is a tendency in a fractional-reserve banking system steadily to increase the issuance of fiduciary media. No bank can afford drastically to exaggerate its note issues, because it would have faced too many redemption claims at once. But if its increases of fiduciary media are small enough—allowing other banks to follow suit—it can steadily increase the issuances.

This analysis led Mises to one of the central contributions of his book: an entirely new business cycle theory. Here Mises created a synthesis of Böhm-Bawerk's capital theory and the business cycle theory of the Currency School.⁷⁶

Mises argued that the issuance of uncovered money substitutes could depress the interest rate below its equilibrium level, thus inciting entrepreneurs to launch investment projects that consume too many resources. Production takes time and thus requires the support of the human beings engaged in production during the entire production period. For a new project to be successful, one needs a sufficient provision of all the goods that the consumers consider to be more important than the goods that will result from this project. Consequently, the realization of additional production projects requires that additional consumers' goods be put at the disposal of the entrepreneurs. These additional consumers' goods can only come from net savings. Without sufficient savings, therefore, no extension of the structure of production is possible. It follows that if new projects are started not because of net savings but only because fractional-reserve banks have depressed the interest rate below its equilibrium level, then the resulting structure of production is unsustainable. It is now physically impossible for all production processes to be carried to completion—there are simply not enough savings to sustain the more extensive structure of production.

The existence of such an unsustainable situation is not immediately evident because the additional investments are made in “higher” production stages, which are removed in time from their final products, the consumers' goods. But as time goes on, it becomes increasingly evident that something has gone deeply wrong in the entire economy. The day of reckoning is reached in what is commonly called an “economic crisis.” Entrepreneurs then discover that not all projects can be carried out as planned for lack of originary capital. Some projects can only be continued in a reduced form, and others have to be stopped altogether. Hence, the material resources and human energies invested in these projects are now seen to have been wasted. Society is impoverished, individuals are out of work, firms go bankrupt, etc.

How can fiduciary media bring about a situation of malinvestment in the first place? Mises argued that this happens when they are brought into circulation through the credit market. In this case, the additional supply of credit reduces the rate of interest, thus pushing it below its equilibrium or “natural” level. Entrepreneurs are able to obtain more credit on better terms and invest these additional funds in new projects in the stages of production most removed from final consumers' goods. Deluded by the increased activities and apparent blossoming of new opportunities, everyone believes at first that the economy is growing faster than before; this is the so-called “boom.” But sooner or later the market participants will become conscious of the fact that this boom is unsustainable, at which point the economy goes “bust”—an economic crisis.

In developing his theory, Mises could rely on two important discoveries of previous thinkers. The first was the business-cycle theory of the British Currency School. According to this school of thought, fractional-reserve banking led to a constant increase of fiduciary media, until the banks (in particular the central bank) proved to be unable to satisfy redemption demands. Then the monetary circulation collapsed because the fiduciary media immediately lost all their value, and this in turn ushered in a crisis.⁷⁷ The second was Knut Wicksell's discovery that monetary expansion could result from discrepancies between the money rate of interest and the equilibrium rate of interest. Yet none of these predecessors had developed the main theme of Mises's business-cycle theory, namely, the causation and propagation of economy-wide error, as well as the notion that the error-ridden process necessarily has to come to an end because it involves an inter-temporal misallocation of resources.⁷⁸

Knut Wicksell

In Wicksell's famous book Geldzins und Güterpreise (Money-Interest and Commodity Prices) he elaborated on David Ricardo's observation that an inflationary monetary policy could reduce the rate of interest only temporarily because sooner or later commodity prices catch up. It followed that any attempt to reduce the interest rate on a permanent basis required constant increases of the money supply. Now, the question was whether any such policy of permanent inflation could be sustainable. Wicksell answered this question by first pointing out that the notion of “reduced interest rate” did not concern any absolute level of the interest rate, but rather a relative comparison of the market rate of money-interest to what he called the natural rate of interest.⁷⁹ He then claimed that indefinite deviations of the money-rate from the natural rate were not possible because the constant influx of new money would sooner or later entail an over-proportional increase of commodity prices, which would induce the banks to adjust the money-rate to the natural rate.⁸⁰ But, as Mises pointed out, Wicksell did not substantiate this claim by showing which mechanism forced the banks to perform such an adjustment.⁸¹ Strictly speaking, Wicksell had no explanation of the business cycle at all, and despite his fundamental distinction between the natural and money rates of interest, he did not see that deviations between these two rates entail an intertemporal misallocation of resources.⁸²

Mises would later develop and refine the business-cycle theory he had presented in his Habilitation work.⁸³ In 1912 he thought he had found merely one out of a number of conceivably complementary explanations of the business cycle. Thus he qualified his findings right in the opening sentence of the concluding § 5: “It is not the task of this work to develop a theory of economic crises. We take account of crisis phenomena only in so far as they can spring from the mechanism of money and fiduciary media.”⁸⁴ He goes on in a somewhat lengthy manner to assert that there might be other sources for business cycles, and in particular that they might also exist in a barter economy. It could well be that these qualifications of the significance of his discoveries were meant to shield him against criticisms from his elders—after all the book was the basis on which he sought to be granted his Habilitation. Be this as it may, Mises eventually made up his mind and came to adopt more definite views on behalf of business-cycle research. Starting from the second edition of Theory of Money and Credit, the qualifications in § 5 are left out, and the first sentence now reads: “Our theory of banking... leads ultimately to a theory of business cycles.”