18. Empirical Evidence for the Theory of the Cycle

In this section we will study how the theory of the business cycle presented in former sections fits in with the history of economic events. In other words we will consider whether or not our theoretical analysis provides an outline suitable for use in interpreting the phenomena of boom and recession which have occurred in history and still continue to occur. Thus we will contemplate how historical events, both those in the distant past and those more recent, illustrate or fit in with the theory we have developed.

Nonetheless it is necessary to begin with a word of caution regarding the historical interpretation of business cycles. Contrary to the assumptions of the “positivist” school, we do not consider empirical evidence alone sufficient to confirm or refute a scientific theory in the field of economics. We deliberately stated that we aim to study how historical events “illustrate” or “fit in with” the theoretical conclusions reached in our analysis, not to carry out an empirical test allowing us to falsify, confirm or demonstrate the validity of our analysis. Indeed though this may not be an appropriate place to reproduce the entire critical analysis of the logical inadequacies of “positivist methodology,”⁸⁰ it is clear that experience in the social realm is always “historical,” i.e., it consists of extremely complex events in which innumerable “variables” are involved. It is not possible to observe these variables directly; we can only interpret them in light of a prior theory. Furthermore both events (with their infinite complexity) and their specific structure vary from one situation to another, and hence, though the typical, underlying forces of greatest significance may be considered the same, their specific historical nature varies substantially from one particular case to another.

Each theory of the cycle will determine a different selection and interpretation of historical events, and this fact gives great significance to the prior establishment, by methodological procedures other than positivist ones, of valid theories which permit the adequate interpretation of reality. Hence no irrefutable historical evidence exists, much less evidence capable of confirming that a theory is valid or invalid. Therefore we should be very cautious and humble in our hopes of empirically corroborating a theory. At most we must be satisfied with developing a logically-coherent theory which is as free as possible of logical defects in its corresponding chain of analytical arguments and is based on the essential principles of human action (“subjectivism”). With this theory at our disposal, the next step is to check how well it fits in with historical events and allows us to interpret actual occurrences in a manner more general, balanced and suitable than other, alternative theories.

These considerations are particularly relevant to the theory of the business cycle. As F.A. Hayek has indicated, the “scientistic” attitude which has so far dominated economics has determined that only economic theories formulated in empirical terms and applicable to measurable magnitudes are heeded. In Hayek's words:

It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know, of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant. The correlation between aggregate demand and total employment, for instance, may only be approximate, but as it is the only one on which we have quantitative data, it is accepted as the only causal connection that counts. On this standard there may thus well exist better “scientific” evidence for a false theory, which will be accepted because it is more “scientific,” than for a valid explanation, which is rejected because there is no sufficient quantitative evidence for it.⁸¹

While taking the above warnings and considerations into account, in this section we will see that the available historical data concerning past cycles of boom and recession fits in excellently with our theory of the cycle. In addition at the end of this section we will review the studies conducted to empirically test the Austrian theory of the business cycle.

BUSINESS CYCLES PRIOR TO THE INDUSTRIAL REVOLUTION

1. It would be impossible to cover here (even in condensed form) all cycles of boom and recession which affected the world's economies prior to the Industrial Revolution. Nevertheless we are fortunate enough to have available to us a growing number of works on economic history which greatly facilitate the application of the theory of the business cycle to specific economic events from the past. We could begin by mentioning Carlo M. Cipolla's works on the crises which gripped the Florentine economy in the mid-fourteenth century and in the sixteenth century, crises we covered in chapter 2.⁸² Indeed we saw that Cipolla, following R.C. Mueller's studies,⁸³ documented the substantial credit expansion Florentine banks brought about starting at the beginning of the fourteenth century.⁸⁴ The result was a significant economic boom that made Florence the center of financial and trade activity in the Mediterranean. Nonetheless a series of events, such as the bankruptcy in England, the withdrawal of funds in Naples, and the crash of Florentine treasury bills triggered the beginning of the inevitable crisis, which manifested itself in widespread bank failure and a strong tightening of credit in the market (or as it was then known, mancamento della credenza). Cipolla points out that the crisis resulted in the destruction of a great stock of wealth, and real estate prices, which had skyrocketed, plummeted to half their former value, and even such a reduction in price was insufficient to attract enough buyers. According to Cipolla, it took thirty years (from 1349 to 1379) for a recovery to begin. In his opinion a major role in the recovery was played by the disastrous plague, which

   broke the vicious spiral of deflation. Since the number of capita was suddenly and dramatically reduced, the average per capita amount of currency available rose. In addition, during the three years that followed the plague, the output of the mint remained high. Consequently, cash balances were unusually large, and they were not hoarded: the prevailing mood among the survivors was that of spending. Thus prices and wages increased.⁸⁵

   In chapter 2 we critically analyzed Cipolla's use of the monetarist theory which underlies his interpretation of Florentine monetary processes.

2. The second economic crisis Cipolla has studied in depth can also be fully accounted for in terms of the Austrian theory of the business cycle. It involves credit expansion which took place during the second half of the sixteenth century in Florence. Specifically, Cipolla explains,

   the managers of the Ricci bank used the public funds as a monetary base for a policy of credit expansion. The preeminence of the Ricci bank in the Florentine market must have lured the other banks into emulating its policy of credit expansion.⁸⁶

   According to Cipolla, during the 1560s the Florentine economy was quite active and was boosted by credit euphoria. However at the beginning of the 1570s the situation culminated in a severe liquidity squeeze which affected the entire banking system. Bankers, as the chroniclers colorfully put it, “only paid in ink.” The crisis gradually grew worse and then violently exploded in the mid-1570s, when a “great shortage of money” (deflation) and a tightening of credit were felt in the city. Cipolla states,

   The credit multiplier suddenly worked perversely, and the Florentine market was throttled by a liquidity crisis, induced by the credit squeeze, that was exceptionally serious both in intensity and length. In the chronicler's pages, in the merchants’ letters, and in the contemporary bans we find continual, concerned references to the monetary and credit “stringency,” to the banks that did not “count” (that is, did not pay out cash), and to the lack of cash to pay workers on Saturdays.⁸⁷

   Therefore credit expansion and the boom were followed by a depression, due to which trade shrank rapidly and bankruptcies were frequent. At that point the Florentine economy fell into a long process of decline.

3. In chapter 2 we also mentioned other credit expansion processes which inevitably gave rise to subsequent economic crises. For example we covered the case of the Venetian Medici Bank, which expanded credit and eventually failed in 1492. In addition we studied, following Ramón Carande, the processes of expansion and bank failure which affected all of Charles V's bankers in the Seville square. Likewise we reflected on the major depression which stemmed from John Law's speculative and financial expansion in France at the beginning of the eighteenth century, expansion which several authors, including Hayek himself, have analyzed in detail.⁸⁸

BUSINESS CYCLES FROM THE INDUSTRIAL REVOLUTION ONWARD

With the Napoleonic Wars, the start of the Industrial Revolution and the spread of the fractional-reserve banking system, business cycles began to reappear with great regularity and acquired the most significant typical features identified by the theory we have presented in this book. We will now briefly touch on the dates and features of the most substantial cycles since the beginning of the nineteenth century.

1. The Panic of 1819. This particularly affected the United States and has been studied chiefly by Murray N. Rothbard in a now classic book on the subject. The panic was preceded by an expansion of credit and of the money supply, both in the form of bank bills and of loans, neither of which were backed by real saving. The newly-created Bank of the United States played a leading role in this process. This produced great artificial economic expansion which was sharply interrupted in 1819, when the bank ceased to expand credit and demanded the payment of other banks’ bills it possessed. The typical tightening of credit followed, along with a deep, widespread economic depression which halted the investment projects initiated during the boom and pushed up unemployment.⁸⁹

2. The Crisis of 1825. This was essentially an English crisis. It was characterized by marked credit expansion, which was used to finance a lengthening of the productive structure, i.e., an addition to the stages furthest from consumption. Such financing consisted basically of investments in the first railroad lines and in the development of the textile industry. In 1825 the crisis erupted, triggering a depression which lasted until 1832.

3. The Crisis of 1836. Banks began again to expand credit, and this led to a boom in which banking companies and corporations multiplied. New loans financed railroads, the iron and steel industry and coal, and the steam engine was developed as a new source of power. At the beginning of 1836 prices began to shoot up. The crisis came to a halt when banks decided to stop increasing their loans in light of the fact that they were losing more and more gold reserves, which were leaving the country, headed mainly for the United States. Starting in 1836 prices plunged and banks failed or suspended payments. The result was a deep depression which lasted until 1840.

4. The Crisis of 1847. As of 1840 credit expansion resumed in the United Kingdom and spread throughout France and the United States. Thousands of miles of railroad track were built and the stock market entered upon a period of relentless growth which mostly favored railroad stock. Thus began a speculative movement which lasted until 1846, when economic crisis hit in Great Britain.

It is interesting to note that on July 19, 1844, under the auspices of Peel, England had adopted the Bank Charter Act, which represented the triumph of Ricardo's currency school and prohibited the issuance of bills not backed 100 percent by gold. Nevertheless this provision was not established in relation to deposits and loans, the volume of which increased five-fold in only two years, which explains the spread of speculation and the severity of the crisis which erupted in 1846. The depression spread to France and the price of railroad stock plummeted in the different stock exchanges. In general profits decreased, particularly in the most capital-intensive industries. Unemployment grew, especially in the sector of railroad construction. It is in this historical context that we should view the (clearly working-class and socialist) revolution which broke out in France in 1848.

5. The Panic of 1857. Its structure resembled that of previous crises. The panic originated in a prior boom which lasted five years, from 1852 to 1857, and which rested on widespread credit expansion of worldwide consequences. Prices, profits and nominal wages rose, and a stock market boom took place. The boom especially favored mining companies and railroad construction companies (the most capital-intensive industries of the period). Moreover speculation became generalized. The first signs of the end of the boom appeared with the start of the decline in mining and railroad profits (the stages furthest from consumption); and the increase in production costs weakened profits further. Subsequently the slowdown impacted the iron, steel and coal industries and the crisis hit. It spread quickly, triggering a worldwide depression. August 22, 1857 was a day of true panic in New York and many banks suspended their operations.

6. The Crisis of 1866. The expansionary stage began in 1861. The evolution of banking in England, and credit expansion initiated by the Credit Foncier in France played a key role. Expansion drove up the price of intermediate goods, construction and cotton-related industries and persisted at a rapid pace until panic broke out in 1866, due to a series of spectacular failures, the most famous of which was that of Overend Gurney in London. At this time, as occurred in 1847 and 1857, Peel's Bank Charter Act was temporarily suspended with the purpose of injecting liquidity into the economy and defending the Bank of England's gold reserves. France's first investment bank, the Crédit Mobiliaire, failed. The above gave rise to a depression which, as always, affected principally the sector of railroad construction, and unemployment spread mostly to capital-goods industries. Between 1859 and 1864, Spain engaged in substantial credit expansion which fostered widespread malinvestment, particularly in railroads. Beginning in 1864 it suffered a recession which reached its peak in 1866. Gabriel Tortella Casares has analyzed this entire process, and although in light of our theory some of his interpretative conclusions should be modified, the events he presents in his writings fit in perfectly with it.⁹⁰

7. The Crisis of 1873. The pattern of this crisis also closely resembled that of prior crises. Expansion was initiated in the United States due to the high costs involved in the Civil War. The railroad network was dramatically enlarged and the iron and steel industries underwent intensive development. Expansion spread to the rest of the world and in Europe there was tremendous stock market speculation in which industrial sector securities soared. Crisis hit first on the Continent in May of 1873 and following the summer in the United States, when recession had become obvious and one of the great American banks, Jay Cook & Co., failed. Notably, France, having abstained from the prior credit expansion, escaped this panic and the serious depression which followed.

8. The Crisis of 1882. Credit expansion resumed in 1878 in the United States and France. In the latter the issuance of industrial shares soared and an ambitious public works program was introduced. Banks played a very active role in attracting family savings and in the massive granting of loans to industry. The crisis erupted in 1882 with the failure of the Union Générale. Also on the verge of failure, the Crédit Lyonnais faced a massive withdrawal of deposits (around half). In the United States over 400 banks (from a total of 3,271) failed, and unemployment and crisis spread mostly to the industries furthest from consumption.

9. The Crisis of 1890–1892. Credit expansion spread throughout the world in the form of loans directed mainly to South America. Shipbuilding and heavy industry developed rapidly. The crisis arose in 1890, and the depression lasted until 1896. The usual bankruptcies of railroad companies, collapse of the stock market, crisis in the iron and steel industries, and unemployment made a violent appearance, as is typical in all depression years following a crisis.

10. The Crisis of 1907. In 1896 credit expansion was again initiated and lasted until 1907. In this case the new loan funds (created ex nihilo) were invested in electric power, telephone, subways, and shipbuilding. Electricity took on the leading role previously played by the railroads. Moreover for the first time the chemical industry took advantage of bank loans and the first automobiles appeared. In 1907 the crisis hit. It was particularly severe in the United States and many banks failed.

Following the crisis of 1907 a new boom began, and in 1913 it culminated in a new crisis similar to previous ones. This new crisis was interrupted by the outbreak of World War I, which altered the productive structure of nearly all countries in the world.⁹¹

THE ROARING TWENTIES AND THE GREAT DEPRESSION OF 1929

The years following the First World War were characterized by the great credit expansion initiated in the United States. The newly-established Federal Reserve (founded in 1913) orchestrated this bout of credit expansion, which revolved around programs to stabilize the value of the monetary unit. Theorists such as Irving Fisher and other monetarists supported these programs, which acquired great, enduring popularity at this point. Given that the decade of the 1920s saw a considerable increase in productivity, in which many new technologies were employed and a large quantity of capital was accumulated, in the absence of such an expansion of the money supply in the form of loans, there would have been a significant decrease in the price of consumer goods and services, and thus a substantial rise in real wages. However credit expansion kept the prices of consumer goods practically constant throughout the entire period.

Benjamin M. Anderson, in his notable financial and economic history of this period in the United States, gives a detailed account of the volume of credit expansion brought about by the American banking system. In little over five years, the amount of the loans created ex nihilo by the banking system grew from $33 billion to over $47 billion. Anderson expressly states that

Between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much, and in the years which followed we paid a terrible price for this.⁹²

Murray N. Rothbard calculates that the money supply in the United States grew from $37 billion in 1921 to over $55 billion in January 1929.⁹³ These figures closely approximate the estimates of Milton Friedman and Anna J. Schwartz, according to whom the money supply increased from over $39 billion in January 1921 to $57 billion in October 1929.⁹⁴

F.A. Hayek himself was a qualified first-hand witness of the expansionary credit policy the Federal Reserve followed in the 1920s. Indeed between 1923 and 1924 he spent fifteen months studying in situ the monetary policy of the U.S. Federal Reserve. One outcome of that stay was his article on American monetary policy following the crisis of 1920.⁹⁵ In this article Hayek critically analyzes the Federal Reserve's objective, according to which

Any rise in the index by a definite percentage is immediately to be met with a rise in the discount rate or other restrictions on credit, and every fall in the general price level by a reduction of the discount rate.⁹⁶

Hayek indicates that the proposal to stabilize the general price level originated with Irving Fisher in the United States and J.M. Keynes and Ralph Hawtrey in England, and that various economists, headed by Benjamin M. Anderson, fiercely criticized it. Hayek's essential theoretical objection to the stabilization project is that, when the general price level is declining, attempts at stabilization invariably take the form of credit expansion, which inevitably provokes a boom, a poor allocation of resources in the productive structure and subsequently, a deep depression. This is what actually happened.

Indeed the goal of stability in the general price level of consumer goods was very nearly achieved throughout the 1920s, at the cost of great credit expansion. This generated a boom which, in keeping with our theoretical predictions, affected mainly capital goods industries. Thus the price of securities increased four-fold in the stock market, and while the production of goods for current consumption grew by 60 percent throughout the period, the production of durable consumer goods, iron, steel, and other fixed capital goods increased by 160 percent.⁹⁷

Another fact which illustrates the Austrian theory of the cycle is the following: during the 1920s wages rose mainly in the capital goods industries. Over an eight-year period they increased in this sector by around 12 percent, in real terms, while they showed an average of 5 percent real growth in the consumer goods industries. In certain capital goods industries wages rose even more. For instance, they increased by 22 percent in the chemical industry and by 25 percent in the iron and steel industry.

Apart from John Maynard Keynes and Irving Fisher, Ralph Hawtrey, the British Treasury's Director of Financial Studies, was another particularly influential economist in terms of justifying credit expansion with the supposedly beneficial goal of keeping the general price level constant. According to Hawtrey,

The American experiment in stabilization from 1922 to 1928 showed that early treatment could shake a tendency either to inflation or to depression in a few months, before any serious damage had been done. The American experiment was a great advance upon the practice of the 19th century.⁹⁸

The policy of credit expansion which was deliberately adopted to keep the general price level stable initially provoked a boom. This boom, along with a lack of the analytical tools necessary to comprehend that the plan would actually cause a deep depression, led authorities to go ahead with the policy, which as we know, was doomed to fail.⁹⁹

The eruption of the crisis surprised monetarists (Fisher, Hawtrey, etc.), who, imbued with a mechanistic concept of the quantity theory of money, believed that once the money supply had been increased, its impact on prices would become stable and irreversible. These theorists did not realize that the expansionary growth in loans exerted a highly unequal effect on the productive structure and relative prices. Professor Irving Fisher was perhaps the most famous American economist at the time, and his comments were among those which most stood out. Fisher obstinately defended the theory that the stock market had reached a level (a high plateau) below which it would never again fall. The 1929 crisis took him by surprise and nearly ruined him.¹⁰⁰

The New York Stock Exchange disaster occurred in stages. Between 1926 and 1929 the share index more than doubled, increasing from 100 to 216. The first warning appeared on Thursday, October 24, 1929, when a supply of thirteen million shares was met with an almost nonexistent demand, and prices collapsed. Banks intervened and were able to momentarily suspend the fall, and prices dropped between twelve and twenty-five points. Though the panic was expected to cease over the weekend, the morning of Monday, October 28 brought a new, unstoppable disaster. Over nine million shares were offered for sale, and the market plunged by forty-nine points. The most devastating day was Tuesday, October 29, when thirty-three million shares were offered and the market plummeted by another forty-nine points.

At that point the depression hit and had the typical characteristics. More than 5,000 banks (out of a total of 24,000) failed or suspended payments between 1929 and 1932.¹⁰¹Furthermore a drastic credit squeeze took place, and gross private investment shrank from over $15 billion in 1929 to barely $1 billion in 1932. In addition unemployment reached its peak in 1933 at around 27 percent of the active population.

The duration and particular severity of the Great Depression, which lasted an entire decade, can only be understood in terms of the economic and monetary policy errors committed principally by the Hoover administration (President Hoover was reelected in 1928), but also by Roosevelt, an interventionist democrat. Virtually all of the most counterproductive measures possible were taken to exacerbate the problems and hinder the arrival of recovery. Specifically a forced and artificial wage support policy drove up unemployment and prevented the transfer of productive resources and labor from one industry to another. Moreover a colossal increase in public spending in 1931 constituted another grave error in economic policy. That year public spending rose from 16.4 percent of the gross domestic product to 21.5 percent, and a deficit of over $2 billion ensued. Authorities mistakenly decided to balance the budget by raising taxes: income taxes increased from 1.5 percent–5 percent to 4 percent–8 percent, many deductions were eliminated and marginal tax rates for the highest income levels jumped. Likewise corporate taxes climbed from 12 to nearly 14 percent, and estate and gift taxes doubled, reaching a maximum rate of 33.3 percent.

Furthermore the public works considered necessary to mitigate the problems of unemployment were financed by the large-scale issuance of government securities, which ultimately absorbed the scarce supply of available capital, crippling the private sector.

Franklin D. Roosevelt, who succeeded Hoover in the 1932 election, continued these harmful policies and carried their disastrous results a step further.¹⁰²

THE ECONOMIC RECESSIONS OF THE LATE 1970S AND EARLY 1990S

The most characteristic feature of the business cycles which have followed World War II is that they have originated in deliberately inflationary policies directed and coordinated by central banks. During the post-war decades and well into the late sixties Keynesian theory led to the belief that an “expansive” fiscal and monetary policy could avert any crisis. Grim reality sank in with the arrival of severe recession in the 1970s, when stagflation undermined and discredited Keynesian assumptions. Moreover the 1970s and the emergence of stagflation actually marked the rebirth of interest in Austrian economics, and Hayek received the 1974 Nobel Prize in Economics precisely for his studies on the theory of the business cycle. As a matter of fact, the crisis and stagflation of the seventies were a “trial by fire” which Keynesians did not survive, and which earned great recognition for Austrian School theorists, who had been predicting it for some time. Their only error, as Hayek admits, lay in their initial misjudgment of the duration of the inflationary process, which, unrestricted by old gold-standard requirements, was prolonged by additional doses of credit expansion and spanned two decades. The result was an unprecedented phenomenon: an acute depression accompanied by high rates of inflation and unemployment.¹⁰³

The crisis of the late seventies belongs to recent economic history and we will not discuss it at length. Suffice it to say that the necessary worldwide adjustment was quite costly. Perhaps after this bitter experience, with the recovery underway, western financial and economic authorities could have been required to take the precautionary measures necessary to avoid a future widespread expansion of credit and thus, a future recession. Unfortunately this was not the case, and despite all of the effort and costs involved in the realignment of western economies following the crisis of the late seventies, the second half of the eighties saw the beginnings of another significant credit expansion which started in the United States and spread throughout Japan, England, and the rest of the world. Despite the stock market's “warnings,” particularly the collapse of the New York Stock Exchange on October 19, 1987, “Black Monday,” (when the New York Stock Exchange Index tumbled 22.6 percent), monetary authorities reacted by nervously injecting massive new doses of credit expansion into the economy to bolster stock market indexes.

In an empirical study on the recession of the early nineties,¹⁰⁴W.N. Butos reveals that between 1983 and 1987 the average rate of annual growth in the reserves provided by the Federal Reserve to the American banking system increased by 14.5 percent per year (i.e., from $25 billion in 1985 to over $40 billion three years later). This led to great credit and monetary expansion, which in turn fed a considerable stock market boom and all sorts of speculative financial operations. Moreover the economy entered a phase of marked expansion which entailed a substantial lengthening of the most capital-intensive stages and a spectacular increase in the production of durable consumer goods. This stage has come to be called the “Golden Age” of the Reagan-Thatcher years, and it rested mainly on the shaky foundation of credit expansion.¹⁰⁵ An empirical study by Arthur Middleton Hughes also confirms these facts. Furthermore Hughes examines the impact of credit expansion and recession on different sectors belonging to various stages of the productive structure (some closer to and some further from consumption). His empirical time-series study confirms the most important conclusions of our theory of the cycle.¹⁰⁶ Moreover this recession was accompanied by a severe bank crisis which in the United States became apparent due to the collapse of several important banks and especially to the failure of the savings and loan sector, the analysis of which has appeared in many publications.¹⁰⁷

This last recession has again surprised monetarists, who cannot understand how such a thing happened.¹⁰⁸ However the expansion's typical characteristics, the arrival of the crisis and the ensuing recession all correspond to the predictions of the Austrian theory of the cycle.

Perhaps one of the most interesting, distinguishing characteristics of the last cycle has been the key role the Japanese economy has played in it. Particularly in the four-year period between 1987 and 1991, the Japanese economy underwent enormous monetary and credit expansion which, as theory suggests, affected mainly the industries furthest from consumption. In fact although the prices of consumer goods rose only by around 0 to 3 percent each year during this period, the price of fixed assets, especially land, real estate, stocks, works of art and jewelry, escalated dramatically. Their value increased to many times its original amount and the respective markets entered a speculative boom. The crisis hit during the second quarter of 1991, and the subsequent recession has lasted more than ten years. A widespread malinvestment of productive resources has become evident, a problem unknown in Japan in the past, and has made it necessary for the Japanese economy to initiate a painful, comprehensive realignment process in which it continues to be involved at the time of this writing (2001).¹⁰⁹

Regarding the effect this worldwide economic crisis has exerted in Spain, it is necessary to note that it violently gripped the country in 1992 and the recession lasted almost five years. All of the typical characteristics of expansion, crisis and recession have again been present in Spain's immediate economic environment, with the possible exception that the artificial expansion was even more exaggerated as a consequence of Spain's entrance into the European Economic Community. Moreover the recession hit within a context of an overvalued peseta, which had to be devalued on three consecutive occasions over a period of twelve months. The stock market was seriously affected, and well-known financial and bank crises arose in an environment of speculation and get-rich-quick schemes. It has taken several years for Spain to recover entirely from these events. Even today, Spanish authorities have yet to adopt all necessary measures to increase the flexibility of the economy, specifically the labor market. Together with a prudent monetary policy and a decrease in public spending and the government deficit, such measures are essential to the speedy consolidation of a stable, sustained recovery process in Spain.¹¹⁰ Finally, following the great Asian economic crisis of 1997, the Federal Reserve orchestrated an expansion of credit in the United States (and throughout the world) which gave rise to an intense boom and stock-market bubble. At this time (late 2001), it appears this situation will very probably end in a stock-market crash (already evident for stocks in the so-called “New Economy” of electronic commerce, new technologies and communications) and a new, deep, worldwide economic recession.¹¹¹

SOME EMPIRICAL TESTING OF THE AUSTRIAN THEORY OF THE BUSINESS CYCLE

Several fascinating studies have lent strong empirical support to the Austrian theory of the business cycle. This has occurred despite the difficulties in testing a theory based on the impact of credit expansion on the productive structure and the irregular manner in which such expansion affects the relative prices of products of the different production stages. It is difficult to empirically test these economic processes, especially while an attempt is made to continue using national accounting statistics, which, as we know, exclude most of the gross value produced in the intermediate stages of the production process. Charles E. Wainhouse has carried out one of these outstanding empirical studies.¹¹² Wainhouse lists nine propositions which he deduces from the Austrian theory of the cycle and empirically tests them one by one.¹¹³ These tests yield several main conclusions. Wainhouse first empirically tests the proposition that changes in the supply of voluntary savings are independent of changes in bank credit. He uses statistical series which date from January 1959 to June 1981 and finds that in all cases but one the empirical evidence confirms this first proposition. Wainhouse's second proposition is that modifications in the supply of credit give rise to changes in the interest rate, and that the two are inversely related. Abundant empirical evidence also exists to support this second proposition. Wainhouse's third proposition states that changes in the rate at which loans are granted cause an increase in the output of intermediate goods, an idea he believes is also corroborated by the evidence he analyzes. The last three propositions Wain-house empirically tests are these: that the ratio of the price of intermediate goods to the price of consumer goods rises following the beginning of credit expansion; that in the expansion process the price of the goods closest to final consumption tends to decrease in relation to the price of intermediate goods; and lastly, that in the final stage of expansion the price of consumer goods increases more rapidly than that of intermediate goods, thus reversing the initial trend. Wainhouse also believes that in general these last three propositions agree with the empirical data, and he therefore concludes that the data supports the theoretical propositions of the Austrian School of economics. Wainhouse leaves three propositions untested, thus leaving open an important field of possible future study for econometricians.¹¹⁴

Another empirical study pertinent to the Austrian theory of the cycle is one conducted by Vladimir Ramey, of the University of California at San Diego.¹¹⁵ Ramey has developed an intertemporal model which breaks down into different stages the inventories which correspond to: consumer goods, wholesale goods, manufactured equipment goods, and intermediate manufactured products. Ramey draws the conclusion that the price of inventories oscillates more the further they are from the final stage of consumption. The inventories closest to consumption are the most stable and vary the least throughout the cycle.

Mark Skousen arrives at a similar conclusion in his analysis of trends in the prices of products from three different production stages: that of finished consumer goods, that of intermediate products, and that of material factors of production. Skousen indicates, as stated in footnote 21, that during the period from 1976 to 1992, the prices of products from the stages furthest from consumption varied from – 10 percent to +30 percent, the prices of intermediate goods only oscillated between +14 percent and –1 percent, and the prices of final consumer goods varied from +12 to –2 percent.¹¹⁶ Moreover Mark Skousen himself estimates that in the crisis of the early nineties, the gross national output of the United States, a measure which includes all goods from intermediate stages, fell by between 10 and 15 percent, and not by the significantly lower percentage (between 1 and 2 percent) reflected by traditional national accounting figures, like gross national product, which exclude all intermediate products, and therefore enormously exaggerate the relative importance of final consumption with respect to the total national productive effort.¹¹⁷

Hopefully the future will bring more frequent and abundant historical-empirical research on the Austrian theory of the business cycle. With luck this research will rest on data from input-output tables and permit the use of the Austrian theory to reform the methodology of the national accounts, thus permitting the gathering of statistical data on variations in relative prices, variations which constitute the microeconomic essence of the business cycle. Table VI-1 is designed to simplify and facilitate this type of empirical research in the future. It summarizes and compares the different phases in the market processes triggered by an increase in society's voluntary saving and those triggered by an expansion of bank credit unbacked by a prior rise in voluntary saving.

CONCLUSION

In light of the theoretical analysis carried out and the historical experience accumulated, it is surprising that at the dawn of the twenty-first century doubts still exist with respect to the recessive nature of credit expansion. We have seen that stages of boom, crisis, and recession recur with great regularity, and we have examined the key role bank credit expansion plays in these stages. Despite these truths, a large number of theorists persist in denying that economic crises stem from an underlying theoretical cause. These theorists fail to realize that their own analysis (be it Keynesian, monetarist, or of any other tendency) relies on the implicit assumption that the monetary factors related to credit play a leading role. These factors are fundamental to understanding the expansion and initial boom, that excessive, continuous increase which invariably takes place in the stock market, and, with the arrival of the crisis, the inevitable credit squeeze and recession, which particularly affects capital-goods industries.

Furthermore it should be obvious that such cycles perpetually recur due to an institutional cause, one capable of accounting for this inherent behavior of (controlled) market economies. As we have been arguing from the beginning of chapter 1, the cause lies in the privilege granted to bankers, allowing them, in violation of traditional legal principles, to loan out the money placed with them on demand deposit, thus operating with a fractional reserve. Governments have also taken advantage of this privilege in order to obtain easy financing in moments of difficulty, and later, via central banks, to guarantee easy credit terms and inflationary liquidity, which until now have been considered necessary and favorable as a stimulus of economic development.

The “gag rule” which has generally been imposed on the Austrian theory of the business cycle is highly significant, as is the widespread public ignorance of the functioning of the financial system. It is as if the two corresponded to an unspoken strategy to avoid change, a strategy which may originate from the desire of many theorists to maintain a justification for government intervention in financial and banking markets, together with the fear and awe most people feel at the idea of confronting banks. Thus we conclude with Mises:

For the nonmonetary explanations of the trade cycle the experience that there are recurrent depressions is the primary thing. Their champions first do not see in their scheme of the sequence of economic events any clue which could suggest a satisfactory interpretation of these enigmatic disorders. They desperately search for a makeshift [explanation] in order to patch it onto their teachings as an alleged cycle theory. The case is different with the monetary or circulating credit theory. Modern monetary theory has finally cleared away all notions of an alleged neutrality of money. It has proved irrefutably that there are in the market economy factors operating about which a doctrine ignorant of the driving force of money has nothing to say.... It has been mentioned already that every nonmonetary explanation of the cycle is bound to admit that an increase in the quantity of money or fiduciary media is an indispensable condition of the emergence of a boom.... The fanaticism with which the supporters of all these nonmonetary doctrines refuse to acknowledge their errors is, of course, a display of political bias.... [T]he interventionists are... anxious to demonstrate that the market economy cannot avoid the return of depressions. They are the more eager to assail the monetary theory as currency and credit manipulation is today the main instrument by means of which the anticapitalist governments are intent upon establishing government omnipotence.¹¹⁸

NOTES ON TABLE VI-1

1. All references to “increases” and “decreases” in prices refer to relative prices, not nominal prices or absolute magnitudes. Thus, for example, an “increase in the prices” of consumer goods indicates that such prices rise, in relative terms, with respect to those of intermediate goods.
2. It is simple to introduce the necessary modifications in the stages of the theoretical processes summarized in the table to include the historical peculiarities of each cycle. Hence if a rise in voluntary saving is accompanied by an increase in hoarding or the demand for money, the phases will remain the same, yet there will be a greater nominal decrease in the price of consumer goods, and a lesser increase in the nominal price of the factors of production. Nonetheless all relationships among relative prices remain just as depicted in the table. In the case of credit expansion, if “idle capacity” exists at its initiation, the nominal price of the factors of production and capital goods will not rise as significantly in the beginning, though the rest of the stages will follow as described, and foolish investments will pile up.
3. Though the number which follows the letter “S” denotes the order of the stages, in certain cases this numbering is relatively arbitrary, depending upon each particular historical situation and whether or not the stages take place more or less simultaneously.
4. In real life the process could come to an indefinite halt during any of the phases, if government intervention makes markets highly rigid, and specifically if the prices of intermediate goods, wages or labor legislation are successfully manipulated. Furthermore a progressive increase in credit expansion may postpone the eruption of the crisis (and/or the liquidation of the malinvestments), but it will make it much deeper and more painful when it inevitably hits.